Calendar No. 496 - U.S. Government Publishing Office€¦ · · 2016-05-0399–010 Calendar No. 496 107TH CONGRESS REPORT 2d Session " SENATE ! 107–211 CARE ACT OF 2002 JULYULY

99–010

Calendar No. 496107TH CONGRESS REPORT " ! SENATE 2d Session 107–211

CARE ACT OF 2002

JULY 16, 2002.—Ordered to be printed

Mr. BAUCUS, from the Committee on Finance, submitted the following

R E P O R T

[To accompany H.R. 7]

The Committee on Finance, to which was referred the bill (H.R. 7) to provide incentives for charitable contributions by individuals and businesses, to improve the effectiveness and efficiency of gov-ernment program delivery to individuals and families in need, and to enhance the ability of low-income Americans to gain financial se-curity by building assets, having considered the same, report favor-ably thereon with an amendment in the nature of a substitute and recommend that the bill as amended do pass.

CONTENTS

Page I. LEGISLATIVE BACKGROUND ..................................................................... 3

II. EXPLANATION OF THE BILL ...................................................................... 4TITLE I. CHARITABLE GIVING INCENTIVES ................................................. 4

A. Charitable Deduction for Nonitemizers (sec. 101 of the bill and secs. 63 and 170 of the Code) ................................................................................ 4

B. Tax-Free Distributions From Individual Retirement Arrangements for Charitable Purposes (sec. 102 of the bill and secs. 408 and 6034 of the Code) ........................................................................................................ 6

C. Charitable Deduction for Contributions of Food Inventory (sec. 103 of the bill and sec. 170 of the Code) ............................................................ 13

D. Charitable Deduction for Contributions of Book Inventory (sec. 104 of the bill and sec. 170 of the Code) ............................................................ 15

E. Expand Charitable Contribution Allowed for Scientific Property Used for Research and for Computer Technology and Equipment (sec. 105 of the bill and sec. 170 of the Code) ............................................................ 17

F. Encourage Contributions of Capital Gain Real Property Made for Con-servation Purposes (sec. 106 of the bill and sec. 170 of the Code) ............ 18

G. Exclusion of 25 Percent of Capital Gain for Certain Sales Made for Qualifying Conservation Purposes (sec. 107 of the bill and new sec. 121A of the Code) .......................................................................................... 21

H. Cost Sharing Payments under the Partners for Fish and Wildlife Program (sec. 108 of the bill and sec. 126 of the Code) ............................. 27

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I. Basis Adjustment to Stock of S Corporation Contributing Property (sec. 109 of the bill and sec. 1367 of the Code) ........................................... 28

J. Enhanced Deduction for Charitable Contribution of Literary, Musical, Artistic, and Scholarly Compositions (sec. 110 of the bill and sec. 170 of the Code) ................................................................................................... 29

TITLE II. DISCLOSURE OF INFORMATION RELATING TO TAX-EXEMPT ORGANIZATIONS ............................................................................................... 31

A. Disclosure of Written Determinations (sec. 201 of the bill and sec. 6110 of the Code) .......................................................................................... 31

B. Disclosure of Internet Web Site and Name Under Which Organization Does Business (sec. 202 of the bill and sec. 6033 of the Code) ................. 35

C. Modification to Reporting of Capital Transactions (sec. 203 of the bill and secs. 6033 and 6104 of the Code) ................................................... 36

D. Disclosure that Form 990 is Publicly Available (sec. 204 of the bill) ...... 37E. Disclosure to State Officials of Proposed Actions Related to Section

501(c) Organizations (sec. 205 of the bill and sec. 6104 of the Code) ....... 37 TITLE III. OTHER CHARITABLE AND EXEMPT ORGANIZATION PROVI-

SIONS ................................................................................................................... 40A. Modify Tax on Unrelated Business Taxable Income of Charitable Re-

mainder Trusts (sec. 301 of the bill and sec. 664 of the Code) ................. 40B. Modify Tax Treatment of Certain Payments to Controlling Exempt

Organizations (sec. 302 of the bill and sec. 512 of the Code) .................... 42C. Simplification of Lobbying Expenditure Limitation (sec. 303 of the

bill and secs. 501 and 4911 of the Code) ..................................................... 43D. Expedited Review Process for Certain Tax-Exemption Applications

(sec. 304 of the bill) ....................................................................................... 47E. Clarification of Definition of Church Tax Inquiry (sec. 305 of the

bill and sec. 7611 of the Code) ..................................................................... 49F. Extension of Declaratory Judgment Procedures to Non-501(c)(3) Tax-

Exempt Organizations (sec. 306 of the bill and sec. 7428 of the Code) .... 50G. Definition of Convention or Association of Churches (sec. 307 of the

bill and sec. 7701 of the Code) ..................................................................... 51H. Charitable Contribution Deduction for Certain Expenses in Support

of Native Alaskan Subsistence Whaling (sec. 308 of the bill and sec. 170 of the Code) ............................................................................................ 52

I. Payments by Charitable Organizations to Victims of War on Terrorism (sec. 309 of the bill) ....................................................................................... 54

J. Modify Rules Governing Tax-Exempt Bonds for Section 501(c)(3) Orga-nizations as Applied to Organizations Engaged in Timber Conservation Activities (sec. 310 of the bill and sec. 145 of the Code) ............................ 55

K. Provide Tax Exemption for Organizations Created by a State to Pro-vide Property and Casualty Insurance Coverage for Property for Which Such Coverage is Otherwise Unavailable (sec. 311 of the bill and sec. 501(c)(28) of the Code) .................................................................................. 57

L. Conform Provisions Relating to Arbitrage Treatment of Certain Uni-versity Fund to State Constitutional Amendments (sec. 312 of the bill) ................................................................................................................. 60

M. Matching Grants to Low-Income Taxpayer Clinics for Return Prepara-tion (sec. 313 of the bill) ............................................................................... 61

N. Increase Percentage Limits for Certain Employer-Related Scholarship Programs (sec. 314 of the bill) ..................................................................... 62

TITLE IV. SOCIAL SERVICES BLOCK GRANT (secs. 401–403 of the bill) ..... 64TITLE V. INDIVIDUAL DEVELOPMENT ACCOUNTS (secs. 501–511 of the

bill) ........................................................................................................................ 65TITLE VI. REVENUE PROVISIONS .................................................................... 69

A. Tax Shelter Transparency Requirements .................................................. 691. Penalty for failure to disclose reportable transactions (sec. 601

of the bill and new sec. 6707A of the Code) ......................................... 692. Modifications to the accuracy-related penalties for listed trans-

actions and reportable transactions having a significant tax avoid-ance purpose (sec. 602 of the bill and new sec. 6662A and secs. 6662 and 6664 of the Code) .................................................................. 74

3. Modifications to the substantial understatement penalty (sec. 603 of the bill and sec. 6662 of the Code) ................................................... 78

4. Tax shelter exception to confidentiality privileges relating to tax-payer communications (sec. 604 of the bill and sec. 7525 of the Code) ....................................................................................................... 79

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5. Disclosure of reportable transactions by material advisors (secs. 611 and 612 of the bill and secs. 6111 and 6707 of the Code) ........... 93

6. Investor lists and applicable penalties (secs. 611 and 613 of the bill and secs. 6112 and 6708 of the Code) ............................................ 96

7. Actions to enjoin conduct with respect to tax shelters (sec. 614 of the bill and sec. 7408 of the Code) ................................................... 98

8. Understatement of taxpayer’s liability by income tax return pre-parer (sec. 621 of the bill and sec. 6694 of the Code) ......................... 99

9. Penalty on failure to report interests in foreign financial accounts (sec. 622 of the bill and sec. 5321 of Title 31, United States Code) .. 100

10. Frivolous tax returns and submissions (sec. 623 of the bill and sec. 6702 of the Code) ............................................................................ 101

11. Regulation of individuals practicing before the Department of the Treasury (sec. 624 of the bill and sec. 330 of Title 31, United States Code) ........................................................................................... 102

12. Penalties on promoters of tax shelters (sec. 625 of the bill and sec. 6700 of the Code) ............................................................................ 103

13. Affirmation of consolidated return regulation authority (sec. 631 of the bill and sec. 1502 of the Code) ................................................... 105

B. Tax Treatment of Inversion Transactions (sec. 641 of the bill and new sec. 7874 of the Code) ........................................................................... 111

C. Reinsurance Agreements (sec. 651 of the bill and sec. 845 of the Code) ................................................................................................ 117

D. Extension of IRS User Fees (sec. 661 of the bill and new sec. 7527 of the Code) ................................................................................... 119

E. Extension of Customs Service User Fees (sec. 671 of the bill) ......... 120 III. BUDGET EFFECTS OF THE BILL ............................................................... 121

A. Committee Estimates .................................................................................. 121 B. Budget Authority and Tax Expenditures ................................................... 122 C. Consultation with Congressional Budget Office ........................................ 122

IV. VOTES OF THE COMMITTEE ...................................................................... 123 V. REGULATORY IMPACT AND OTHER MATTERS ..................................... 124

A. Regulatory Impact ....................................................................................... 124 B. Unfunded Mandates Statement .................................................................. 124 C. Tax Complexity Analysis ............................................................................. 125

VI. CHANGES IN EXISTING LAW MADE BY THE BILL AS REPORTED 127

I. LEGISLATIVE BACKGROUND

Overview H.R. 7 (the ‘‘Community Solutions Act of 2001’’) was passed by

the House of Representatives on July 19, 2001. H.R. 7 was referred to the Senate Committee on Finance on July 19, 2001. The Senate Committee on Finance marked up the bill on June 13, 2002, and June 18, 2002. The bill, as amended by an amendment in the na-ture of a substitute, was ordered reported on June 18, 2002 by voice vote.

Committee hearings The Committee held a hearing regarding encouraging charitable

giving on March 14, 2001. The Committee held a hearing on March 21, 2002, regarding the

proliferation of tax shelters. At such hearing, notice was given that the Committee intended to take action to curtail the benefits of in-version transactions

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1 All section references are to the Internal Revenue Code of 1986, unless otherwise indicated. 2 Secs. 170(b) and (e). 3 Sec. 170(a). The Economic Recovery Tax Act of 1981 adopted a temporary provision that per-

mitted individual taxpayers who did not itemize income tax deductions to claim a deduction from gross income for a specified percentage of their charitable contributions. The maximum de-duction was $25 for 1982 and 1983, $75 for 1984, 50 percent of the amount of the contribution for 1985, and 100 percent of the amount of the contribution for 1986. The nonitemizer deduction terminated after 1986.

4 See. 170(f)(8). 5 Sec. 6115.

II. EXPLANATION OF THE BILL

Title I. Charitable Giving Incentives

A. CHARITABLE DEDUCTION FOR NONITEMIZERS

(Sec. 101 of the bill and secs. 63 and 170 of the Code)

PRESENT LAW

In computing taxable income, an individual taxpayer who itemizes deductions generally is allowed to deduct the amount of cash and up to the fair market value of property contributed to a charity described in section 501(c)(3) 1 or a Federal, State, or local governmental entity. The deduction also is allowed for purposes of calculating alternative minimum taxable income.

The amount of the deduction allowable for a taxable year with respect to a charitable contribution of property may be reduced de-pending on the type of property contributed, the type of charitable organization to which the property is contributed, and the income of the taxpayer.2

A taxpayer who takes the standard deduction (i.e., who does not itemize deductions) may not take a separate deduction for chari-table contributions.3

A payment to a charity (regardless of whether it is termed a ‘‘contribution’’) in exchange for which the donor receives an eco-nomic benefit is not deductible, except to the extent that the donor can demonstrate that the payment exceeds the fair market value of the benefit received from the charity. To facilitate distinguishing charitable contributions from purchases of goods or services from charities, present law provides that no charitable contribution de-duction is allowed for a separate contribution of $250 or more un-less the donor obtains a contemporaneous written acknowledge-ment of the contribution from the charity indicating whether the charity provided any good or service (and an estimate of the value of any such good or service) to the taxpayer in consideration for the contribution.4 In addition, present law requires that any charity that receives a contribution exceeding $75 made partly as a gift and partly as consideration for goods or services furnished by the charity (a ‘‘quid pro quo’’ contribution) is required to inform the contributor in writing of an estimate of the value of the goods or services furnished by the charity and that only the portion exceed-ing the value of the goods or services is deductible as a charitable contribution.5

Under present law, total deductible contributions of an individual taxpayer to public charities, private operating foundations, and cer-tain types of private nonoperating foundations may not exceed 50 percent of the taxpayer’s contribution base, which is the taxpayer’s


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adjusted gross income for a taxable year (disregarding any net op-erating loss carryback). To the extent a taxpayer has not exceeded the 50-percent limitation, (1) contributions of capital gain property to public charities generally may be deducted up to 30 percent of the taxpayer’s contribution base, (2) contributions of cash to private foundations and certain other charitable organizations generally may be deducted up to 30 percent of the taxpayer’s contribution base, and (3) contributions of capital gain property to private foun-dations and certain other charitable organizations generally may be deducted up to 20 percent of the taxpayer’s contribution base.

Contributions by individuals in excess of the 50-percent, 30-per-cent, and 20-percent limit may be carried over and deducted over the next five taxable years, subject to the relevant percentage limi-tations on the deduction in each of those years.

In addition to the percentage limitations imposed specifically on charitable contributions, present law imposes a reduction on most itemized deductions, including charitable contribution deductions, for taxpayers with adjusted gross income in excess of a threshold amount, which is indexed annually for inflation. The threshold amount for 2002 is $137,300 ($68,650 for married individuals filing separate returns). For those deductions that are subject to the limit, the total amount of itemized deductions is reduced by three percent of adjusted gross income over the threshold amount, but not by more than 80 percent of itemized deductions subject to the limit. Beginning in 2006, the overall limitation on itemized deduc-tions phases-out for all taxpayers. The overall limitation on itemized deductions is reduced by one-third in taxable years begin-ning in 2006 and 2007, and by two-thirds in taxable years begin-ning in 2008 and 2009. The overall limitation on itemized deduc-tions is eliminated for taxable years beginning after December 31, 2009; however, this elimination of the limitation sunsets on Decem-ber 31, 2010.

REASONS FOR CHANGE

The Committee recognizes that the Administration believes that providing a charitable deduction for taxpayers who do not itemize deductions will result in an increase in charitable giving. In addi-tion, the Committee appreciates that the charitable deduction is an important part of the President’s faith-based initiative. The pro-posal is for a two-year period. To provide Congress adequate infor-mation in considering extending the proposal, the Committee re-quires the Secretary of the Treasury to submit a report on the ef-fectiveness of the provision. The report should consider the extent to which charitable giving has increased, the burdens of complexity to taxpayers and the impact on tax compliance.

EXPLANATION OF PROVISION

In the case of an individual taxpayer who does not itemize deduc-tions, the provision allows a ‘‘direct charitable deduction’’ from ad-justed gross income for charitable contributions paid in cash during the taxable year. This deduction is allowed in addition to the standard deduction. The deduction is available only for that portion of contributions actually made during the year that in the aggre-gate exceed $250 ($500 in the case of a joint return). The maximum deduction is $250 ($500 in the case of a joint return). Contributions


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that are below the minimum amount or that exceed the maximum deduction may not be carried over for purposes of a subsequent taxable year’s calculation of the direct charitable deduction. Under the provision, an individual is not entitled to a charitable deduction for the first $250 of cash contributions made during the tax year, is entitled to a deduction on a dollar-for-dollar basis for contribu-tions of $251 to $500 (e.g., a $1 contribution deduction in the case of $251 of contributions, and a $250 deduction in the case of $500 of contributions), and is not entitled to a deduction for contribu-tions exceeding $500.

The provision does not alter present-law rules regarding the car-ryover of contributions to or from a taxable year, including a tax-able year in which the taxpayer elects the standard deduction. The direct charitable deduction generally is subject to the tax rules nor-mally governing charitable contribution deductions, such as the substantiation requirements. The deduction is allowed in com-puting alternative minimum taxable income.

The provision requires the Secretary of the Treasury to complete a study by December 31, 2003, of the effect of the provision on in-creased charitable giving, and of taxpayer compliance, for example, by comparing compliance by taxpayers who itemize their charitable contributions with compliance by those who claim the direct chari-table deduction. The Secretary shall report on the study to the Committee on Finance of the Senate and the Committee on Ways and Means of the House of Representatives.

EFFECTIVE DATE

The direct charitable deduction is effective for taxable years be-ginning after December 31, 2001, and before January 1, 2004. The Treasury study is required by December 31, 2003.

B. TAX-FREE DISTRIBUTIONS FROM INDIVIDUAL RETIREMENT ARRANGEMENTS FOR CHARITABLE PURPOSES


PRESENT LAW

In general If an amount withdrawn from a traditional individual retirement

arrangement (‘‘IRA’’) or a Roth IRA is donated to a charitable orga-nization, the rules relating to the tax treatment of withdrawals from IRAs apply to the amount withdrawn and the charitable con-tribution is subject to the normally applicable limitations on de-ductibility of such contributions.

Charitable contributions In computing taxable income, an individual taxpayer who

itemizes deductions generally is allowed to deduct the amount of cash and up to the fair market value of property contributed to a charity described in section 501(c)(3) or a Federal, State, or local governmental entity. The deduction also is allowed for purposes of calculating alternative minimum taxable income.

The amount of the deduction allowable for a taxable year with respect to a charitable contribution of property may be reduced de-pending on the type of property contributed, the type of charitable


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6 Secs. 170(b) and (e). 7 Sec, 170(a). The Economic Recovery Tax Act of 1981 adopted a temporary provision that per-

mitted individual taxpayers who did not itemize income tax deductions to claims a deduction from gross income for a specified percentage of their charitable contributions. The maximum de-duction was $25 for 1982 and 1983, $75 for 1984, 50 percent of the amount of the contribution for 1985, and 100 percent of the amount of the contribution for 1986. The nonitemizer deduction terminated after 1986.

8 Sec. 170(f)(8). 9 Sec. 6115.

organization to which the property is contributed, and the income of the taxpayer.6

A taxpayer who takes the standard deduction (i.e., who does not itemize deductions) may not take a separate deduction for chari-table contributions.7

A payment to a charity (regardless of whether it is termed a ‘‘contribution’’) in exchange for which the donor receives an eco-nomic benefit is not deductible, except to the extent that the donor can demonstrate that the payment exceeds the fair market value of the benefit received from the charity. To facilitate distinguishing charitable contributions from purchases of goods or services from charities, present law provides that no charitable contribution de-duction is allowed for a separate contribution of $250 or more un-less the donor obtains a contemporaneous written acknowledge-ment of the contribution from the charity indicating whether the charity provided any good or service (and an estimate of the value of any such good or service) to the taxpayer in consideration for the contribution.8 In addition, present law requires that any charity that receives a contribution exceeding $75 made partly as a gift and partly as consideration for goods or services furnished by the charity (a ‘‘quid pro quo’’ contribution) is required to inform the contributor in writing of an estimate of the value of the goods or services furnished by the charity and that only the portion exceed-ing the value of the goods or services is deductible as a charitable contribution.9

Under present law, total deductible contributions of an individual taxpayer to public charities, private operating foundations, and cer-tain types of private nonoperating foundations may not exceed 50 percent of the taxpayer’s contribution base, which is the taxpayer’s adjusted gross income for a taxable year (disregarding any net op-erating loss carryback). To the extent a taxpayer has not exceeded the 50-percent limitation, (1) contributions of capital gain property to public charities generally may be deducted up to 30 percent of the taxpayer’s contribution base, (2) contributions of cash to private foundations and certain other charitable organizations generally may be deducted up to 30 percent of the taxpayer’s contribution base, and (3) contributions of capital gain property to private foun-dations and certain other charitable organizations generally may be deducted up to 20 percent of the taxpayer’s contribution base.

Contributions by individuals in excess of the 50-percent, 30-per-cent, and 20-percent limit may be carried over and deducted over the next five taxable years, subject to the relevant percentage limi-tations on the deduction in each of those years.

In addition to the percentage limitations imposed specifically on charitable contributions, present law imposes a reduction on most itemized deductions, including charitable contribution deductions, for taxpayers with adjusted gross income in excess of a threshold amount, which is indexed annually for inflation. The threshold

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10 Secs. 170(f), 2055(e)(2), and 2522(c)(2). 11 Sec. 170(f)(2).

amount for 2002 is $137,300 ($68,650 for married individuals filing separate returns). For those deductions that are subject to the limit, the total amount of itemized deductions is reduced by three percent of adjusted gross income over the threshold amount, but not by more than 80 percent of itemized deductions subject to the limit. Beginning in 2006, the overall limitation on itemized deduc-tions phases-out for all taxpayers. The overall limitation on itemized deductions is reduced by one-third in taxable years begin-ning in 2006 and 2007, and by two-thirds in taxable years begin-ning in 2008 and 2009. The overall limitation on itemized deduc-tions is eliminated for taxable years beginning after December 31, 2009; however, this elimination of the limitation sunsets on Decem-ber 31, 2010.

In general, a charitable deduction is not allowed for income, es-tate, or gift tax purposes if the donor transfers an interest in prop-erty to a charity (e.g., a remainder) while also either retaining an interest in that property (e.g., an income interest) or transferring an interest in that property to a noncharity for less than full and adequate consideration.10 Exceptions to this general rule are pro-vided for, among other interests, remainder interests in charitable remainder annuity trusts, charitable remainder unitrusts, and pooled income funds, and present interests in the form of a guaran-teed annuity or a fixed percentage of the annual value of the prop-erty.11 For such interests, a charitable deduction is allowed to the extent of the present value of the interest designated for a chari-table organization.

IRA rules Within limits, individuals may make deductible and nondeduct-

ible contributions to a traditional IRA. Amounts in a traditional IRA are includible in income when withdrawn (except to the extent the withdrawal represents a return of nondeductible contributions). Individuals also may make nondeductible contributions to a Roth IRA. Qualified withdrawals from a Roth IRA are excludable from gross income. Withdrawals from a Roth IRA that are not qualified withdrawals are includible in gross income to the extent attrib-utable to earnings. Includible amounts withdrawn from a tradi-tional IRA or a Roth IRA before attainment of age 591⁄2 are subject to an additional 10-percent early withdrawal tax, unless an excep-tion applies.

If an individual has made nondeductible contributions to a tradi-tional IRA, a portion of each distribution from an IRA is non-taxable, until the total amount of nondeductible contributions has been received. In general, the amount of a distribution that is non-taxable is determined by multiplying the amount of the distribu-tion by the ratio of the remaining nondeductible contributions to the account balance. In making the calculation, all traditional IRAs of an individual are treated as a single IRA, all distributions dur-ing any taxable year are treated as a single distribution, and the value of the contract, income on the contract, and investment in the contract are computed as of the close of the calendar year.


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12 Conversion contributions refer to conversions of amounts in a traditional IRA to a Roth IRA. 13 Sec. 6034. This requirement applies to all split-interest trusts described in section

4947(a)(2). 14 Sec. 642(c). 15 Sec. 6104(b). 16 Sec. 6011; Treas. Reg. sec. 53.6011–1(d).

In the case of a distribution from a Roth IRA that is not a quali-fied distribution, in determining the portion of the distribution at-tributable to earnings, contributions and distributions are deemed to be distributed in the following order: (1) regular Roth IRA con-tributions; (2) taxable conversion contributions;12 (3) nontaxable conversion contributions; and (4) earnings. In determining the amount of taxable distributions from a Roth IRA, all Roth IRA dis-tributions in the same taxable year are treated as a single distribu-tion, all regular Roth IRA contributions for a year are treated as a single contribution, and all conversion contributions during the year are treated as a single contribution.

Split-interest trust filing requirements Split-interest trusts, including charitable remainder annuity

trusts, charitable remainder unitrusts, and pooled income funds, are required to file an annual information return 13 (Form 1041A). Trusts that are not split-interest trusts but that claim a charitable deduction for amounts permanently set aside for a charitable pur-pose 14 also are required to file Form 1041A. The returns are re-quired to be made publicly available.15 A trust that is required to distribute all trust net income currently to trust beneficiaries in a taxable year is exempt from this return requirement for such tax-able year. A failure to file the required return may result in a pen-alty on the trust of $10 a day for as long as the failure continues, up to a maximum of $5,000 per return.

In addition, split-interest trusts are required to file annually Form 5227.16 Form 5227 requires disclosure of information regard-ing a trust’s noncharitable beneficiaries. The penalty for failure to file this return is calculated based on the amount of tax owed. A split-interest trust generally is not subject to tax and therefore, in general, a penalty may not be imposed for the failure to file Form 5227. Form 5227 is not required to be made publicly available.

REASONS FOR CHANGE

Under present law, an individual who wants to use IRA proceeds to make charitable contributions must treat the IRA distribution as a withdrawal subject to IRA income recognition rules and is subject to deduction limitation provisions on the contributions made to the charity.

In some cases, this can result in taxable income even though the individual used the entire IRA distribution to make the charitable contribution. The Committee believes that taxpayers who want to make charitable contributions from IRAs generally should be per-mitted to do so without recognizing income because of the distribu-tion from the IRA, whether such contribution is made directly to the charitable organization or indirectly through the use of a split-interest entity. The Committee believes that facilitating charitable contributions from IRAs will help increase giving to charitable or-ganizations.


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Qualified charitable distributions from IRAs The provision provides an exclusion from gross income for other-

wise taxable IRA distributions from a traditional or a Roth IRA in the case of qualified charitable distributions. Special rules apply in determining the amount of an IRA distribution that is otherwise taxable. The present-law rules regarding taxation of IRA distribu-tions and the deduction of charitable contributions continue to apply to distributions from an IRA that are not qualified charitable distributions.

A qualified charitable distribution is defined as any distribution from an IRA that is made directly by the IRA trustee either to (1) an organization to which deductible contributions can be made (a ‘‘direct distribution’’) or (2) a ‘‘split-interest entity.’’ A split-interest entity means a charitable remainder annuity trust or charitable re-mainder unitrust (together referred to as a ‘‘charitable remainder trust’’), a pooled income fund, or a charitable gift annuity. Direct distributions are eligible for the exclusion only if made on or after the date the IRA owner attains age 701⁄2. Distributions to a split interest entity are eligible for the exclusion only if made on or after the date the IRA owner attains age 591⁄2. In the case of split-inter-est distributions, no person may hold an income interest in the amounts in the split-interest entity attributable to the charitable distribution other than the IRA owner, his or her spouse, or a char-itable organization.

The exclusion applies to direct distributions only if a charitable contribution deduction for the entire distribution would otherwise be allowable, determined without regard to the generally applicable percentage limitations. Thus, for example, if the deductible amount is reduced because of a benefit received in exchange, or if a deduc-tion is not allowable because the donor did not obtain sufficient substantiation, the exclusion is not available with respect to any part of the IRA distribution. Similarly, the exclusion applies in the case of a distribution directly to a split-interest entity only if a charitable contribution deduction for the entire present value of the charitable interest (for example, a remainder interest) is allowable, determined without regard to the generally applicable percentage limitations.

If the IRA owner has any IRA that includes nondeductible con-tributions, a special rule applies in determining the portion of a distribution that is includible in gross income (but for the provi-sion) and thus is eligible for qualified charitable distribution treat-ment. In such case, the IRA owner aggregates all IRAs to deter-mine eligibility for the exclusion. Under the special rule, the dis-tribution is treated as consisting of income first, up to the aggre-gate amount that is includible in gross income (but for the provi-sion) if all amounts were distributed from all IRAs otherwise taken into account in determining the amount of IRA distributions during the year that is includible in income. In determining the amount of subsequent IRA distributions includible in income, proper adjust-ments are made to reflect the amount treated as a qualified chari-table distribution under the special rule.

Special rules apply for distributions to split-interest entities. For distributions to charitable remainder trusts, the provision provides


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that subsequent distributions from the charitable remainder trust are treated as ordinary income in the hands of the beneficiary, not-withstanding how such amounts normally are treated under sec-tion 664(b). In addition, for a charitable remainder trust to be eligi-ble to receive qualified charitable distributions, the charitable re-mainder trust has to be funded exclusively by such distributions. For example, an IRA owner may not make qualified charitable dis-tributions to an existing charitable remainder trust any part of which was funded with assets that were not qualified charitable distributions.

Under the provision, a pooled income fund is eligible to receive qualified charitable distributions only if the fund accounts sepa-rately for amounts attributable to such distributions. In addition, all distributions from the pooled income fund that are attributable to qualified charitable distributions are treated as ordinary income to the beneficiary. Qualified charitable distributions to a pooled in-come fund are not includible in the fund’s gross income.

In determining the amount includible in gross income by reason of a payment from a charitable gift annuity purchased with a quali-fied charitable distribution from an IRA, the portion of the dis-tribution from the IRA used to purchase the annuity is not an in-vestment in the annuity contract.

Any amount excluded from gross income by reason of the provi-sion is not taken into account in determining the deduction for charitable contributions under section 170.

Qualified charitable distribution examples The following examples illustrate the determination of the por-

tion of an IRA distribution that is a qualified charitable distribu-tion and the application of the special rules for a qualified chari-table distribution to a split-interest entity. In each example, it is assumed that the requirements for qualified charitable distribution treatment are otherwise met (e.g., the applicable age requirement and the requirement that contributions are otherwise deductible) and that no other IRA distributions occur during the year.

Example 1. Individual A has a traditional IRA with a balance of $100,000, consisting solely of deductible contributions and earn-ings. Individual A has no other IRA. The entire IRA balance is dis-tributed in a direct distribution to a charitable organization. Under present law, the entire distribution of $100,000 would be includible in Individual A’s income. Accordingly, under the provision, the en-tire distribution of $100,000 is a qualified charitable distribution. As a result, no amount is included in Individual A’s income as a result of the distribution and the distribution is not taken into ac-count in determining the amount of Individual A’s charitable de-duction for the year.

Example 2. The facts are the same as in Example 1, except that the entire IRA balance of $100,000 is distributed to a charitable re-mainder unitrust, which contains no other assets. Under the terms of the trust, Individual A is entitled to receive five percent of the value of the trust each year. As explained in Example l, the entire $100,000 distribution is a qualified charitable distribution, no amount is included in Individual A’s income as a result of the dis-tribution, and the distribution is not taken into account in deter-mining the amount of Individual A’s charitable deduction for the


12

17 Sec. 6652(c)(4)(C).

year. In addition, under a special rule in the provision for chari-table remainder trusts, any distribution from the charitable re-mainder unitrust to Individual A is includible in gross income as ordinary income, regardless of the character of the distribution under the usual rules for the taxation of distributions from such a trust.

Example 3. Individual B has a traditional IRA with a balance of $100,000, consisting of $20,000 of nondeductible contributions and $80,000 of deductible contributions and earnings. Individual B has no other IRA. In a direct distribution to a charitable organization, $80,000 is distributed from the IRA. Under present law, a portion of the distribution from the IRA would be treated as a nontaxable return of nondeductible contributions. The nontaxable portion of the distribution would be $16,000, determined by multiplying the amount of the distribution ($80,000) by the ratio of the nondeduct-ible contributions to the account balance ($20,000/$100,000). Ac-cordingly, under present law, $64,000 of the distribution ($80,000 minus $16,000) would be includible in Individual B’s income.

Under the provision, notwithstanding the present-law tax treat-ment of IRA distributions, the distribution is treated as consisting of income first, up to the total amount that would be includible in gross income (but for the provision) if all amounts were distributed from all IRAs otherwise taken into account in determining the amount of IRA distributions. The total amount that would be in-cludible in income if all amounts were distributed from the IRA is $80,000. Accordingly, under the provision, the entire $80,000 dis-tributed to the charitable organization is treated as includible in income (before application of the provision) and is a qualified chari-table distribution. As a result, no amount is included in Individual B’s income as a result of the distribution and the distribution is not taken into account in determining the amount of Individual B’s charitable deduction for the year. In addition, for purposes of deter-mining the tax treatment of other distributions from the IRA, $20,000 of the amount remaining in the IRA is treated as Indi-vidual B’s nondeductible contributions.

Split-interest trust filing requirements The provision increases the penalty on split-interest trusts for

failure to file a return and for failure to include any of the informa-tion required to be shown on such return and to show the correct information. The penalty is $20 for each day the failure continues up to $10,000 for any one return. In the case of a split-interest trust with gross income in excess of $250,000, the penalty is $100 for each day the failure continues up to a maximum of $50,000. In addition, if a person (meaning any officer, director, trustee, em-ployee, or other individual who is under a duty to file the return or include required information) 17 knowingly failed to file the re-turn or include required information, then that person is personally liable for such a penalty, which would be imposed in addition to the penalty that is paid by the organization. Information regarding beneficiaries that are not charitable organizations as described in section 170(c) is exempt from the requirement to make information publicly available. In addition, the provision repeals the present-


13

18 Sec. 170(e)(3). In general, a C corporation’s charitable contribution deductions for a year may not exceed 10 percent of the corporation’s taxable income. Sec. 170(b)(2).

19 Lucky Stores Inc. v. Commissioner, 105 T.C. 420 (1995).

law exception to the filing requirement for split-interest trusts that are required in a taxable year to distribute all net income currently to beneficiaries. Such exception remains available to trusts other than split-interest trusts that are otherwise subject to the filing re-quirement.

EFFECTIVE DATE

The provision generally is effective for taxable years beginning after December 31, 2002. The provision relating to information re-turns of split-interest trusts is effective for returns for taxable years beginning after December 31, 2002.

C. CHARITABLE DEDUCTION FOR CONTRIBUTIONS OF FOOD INVENTORY

(Sec. 103 of the bill and sec. 170 of the Code)

PRESENT LAW

Under present law, a taxpayer’s deduction for charitable con-tributions of inventory generally is limited to the taxpayer’s basis (typically, cost) in the inventory.

However, for certain contributions of inventory, C corporations may claim an enhanced deduction equal to the lesser of (1) basis plus one-half of the item’s appreciated value (i.e., basis plus one half of fair market value in excess of basis) or (2) two times basis.18 To be eligible for the enhanced deduction, the contributed property generally must be inventory of the taxpayer, contributed to a chari-table organization described in section 501(c)(3) (except for private nonoperating foundations), and the donee must (1) use the property consistent with the donee’s exempt purpose solely for the care of the ill, the needy, or infants, (2) not transfer the property in ex-change for money, other property, or services, and (3) provide the taxpayer a written statement that the donee’s use of the property will be consistent with such requirements. In the case of contrib-uted property subject to the Federal Food, Drug, and Cosmetic Act, the property must satisfy the applicable requirements of such Act on the date of transfer and for 180 days prior to the transfer.

To use the enhanced deduction, the taxpayer must establish that the fair market value of the donated item exceeds basis. The valu-ation of food inventory has been the subject of ongoing disputes be-tween taxpayers and the IRS. In one case, the Tax Court held that the value of surplus bread inventory donated to charity was the full retail price of the bread rather than half the retail price, as the IRS asserted.19

REASONS FOR CHANGE

The Committee believes that expanding the present-law en-hanced deduction for contributions of food inventory to non-C cor-porations will increase charitable contributions of food to those in need. By clarifying the definition of fair market value, the Com-mittee believes that taxpayers will be better able to avoid disputes with the IRS about the valuation of food and receive an appropriate


14

20 This includes, for example, taxpayers who are eligible for administrative relief under Rev-enue Procedures 2002–28 and 2001–10.

deduction for their contribution. In addition, the Committee be-lieves that providing certain low-basis taxpayers with a deemed basis equal to one quarter of the fair market value of the food will increase food donations, thus further providing needed nourish-ment to the nation’s hungry.


Under the provision, any taxpayer, whether or not a C corpora-tion, engaged in a trade or business is eligible to claim the en-hanced deduction for donations of food inventory. For taxpayers other than C corporations, the total deduction for donations of food inventory in a taxable year generally may not exceed 10 percent of the taxpayer’s net income for such year from its trade or business (or interest therein) from which contributions are made. For exam-ple, if a taxpayer is a sole proprietor, a shareholder in an S cor-poration, and a partner in a partnership, and each business makes charitable contributions of food inventory, the taxpayer’s deduction for donations of food inventory is limited to 10 percent of the tax-payer’s net income from the sole proprietorship, and the taxpayer’s interests in the S corporation and partnership. However, if only the sole proprietorship and the S corporation made charitable contribu-tions of food inventory, the taxpayer’s deduction would be limited to 10 percent of the net income from the trade or business of the sole proprietorship and the S corporation, but not the partnership.

The 10 percent limitation does not affect the application of the generally applicable percentage limitations. For example, if 10 per-cent of a sole proprietor’s net income from the proprietor’s trade or business was greater than 50 percent of the proprietor’s contribu-tion base, the available deduction for the taxable year (with respect to contributions to public charities) would be 50 percent of the pro-prietor’s contribution base. Consistent with present law, such con-tributions may be carried forward because they exceed the 50 per-cent limitation. Contributions of food inventory by a taxpayer that is not a C corporation that exceed the 10 percent limitation but not the 50 percent limitation could not be carried forward.

For purposes of calculating the enhanced deduction, taxpayers who do not account for inventories under section 471 and who are not required to capitalize indirect costs under section 263A are able to elect to treat the basis of the contributed food as being equal to 25 percent of the food’s fair market value.20

Under the provision, the enhanced deduction is available only for food that qualifies as ‘‘apparently wholesome food.’’ ‘‘Apparently wholesome food’’ is defined as food intended for human consump-tion that meets all quality and labeling standards imposed by Fed-eral, State, and local laws and regulations even though the food may not be readily marketable due to appearance, age, freshness, grade, size, surplus, or other conditions.

In addition, the provision provides that the fair market value of donated apparently wholesome food that cannot or will not be sold solely due to internal standards of the taxpayer or lack of market is determined without regard to such internal standards or lack of market and by taking into account the price at which the same or


15

21 Sec. 170(e)(3).

substantially the same food items are sold by the taxpayer at the time of the contribution or, if not so sold at such time, in the recent past.

EFFECTIVE DATE

The provision is effective for taxable years beginning after De-cember 31, 2002.

D. CHARITABLE DEDUCTION FOR CONTRIBUTIONS OF BOOK INVENTORY


PRESENT LAW

Under present law, a taxpayer’s deduction for charitable con-tributions of inventory generally is limited to the taxpayer’s basis (typically, cost) in the inventory.

However, for certain contributions of inventory, C corporations may claim an enhanced deduction equal to the lesser of (1) basis plus one-half of the item’s appreciated value (i.e., basis plus one half of fair market value in excess of basis) or (2) two times basis.21 To be eligible for the enhanced deduction, the contributed property generally must be inventory of the taxpayer, contributed to a chari-table organization described in section 501(c)(3) (except for private nonoperating foundations), and the donee must: (1) use the prop-erty consistent with the donee’s exempt purpose solely for the care of the ill, the needy, or infants, (2) not transfer the property in ex-change for money, other property, or services, and (3) provide the taxpayer a written statement that the donee’s use of the property will be consistent with such requirements.

REASONS FOR CHANGE

Under present law, taxpayers sometimes are prohibited from re-ceiving an enhanced deduction for charitable contributions of their book inventory, in part because of the requirement that the inven-tory be used for care of the ill, the needy, or infants. For example, such requirement generally prohibits donations to public libraries and adult literacy programs. The Committee believes that suitable book inventory should be eligible for an enhanced deduction in cases where a contribution is made to an appropriate educational organization. To minimize disputes between taxpayers and the IRS about the value of books and to encourage contributions of books that are suitable in terms of currency, content, and quantity, the Committee provides a special rule for determining the amount of the contribution of such books. A clear rule is needed so that tax-payers know that if they donate books to schools, libraries, and lit-eracy programs, they will receive an enhanced deduction that more adequately reflects the costs of the donation.


The provision modifies the present-law enhanced deduction for C corporations so that it is equal to the lesser of fair market value or twice the taxpayer’s basis in the case of qualified book contribu-


16

tions. The provision provides that the fair market value for this purpose is determined by reference to a bona fide published market price for the book (using the same printing and same edition), pub-lished within seven years preceding the contribution. The Com-mittee intends that a bona fide published market price of a book would be a price that was reached as a result of an arm’s length transaction within the seven years preceding the contribution, and for which the book was customarily sold. A publisher’s listed retail price for a book would not meet the standard unless the publisher could demonstrate to the satisfaction of the Secretary that the price was one at which the book was customarily sold. For example, if a publisher entered into a contract with a local school district to sell textbooks six years prior to making a qualified book contribu-tion of such textbooks, the publisher could use as a ‘‘bona fide pub-lished market price,’’ the price at which such books were regularly sold to the school district under the contract. By contrast, if a pub-lisher listed in a catalogue or elsewhere a ‘‘suggested retail price,’’ but books were not in fact frequently sold at such price, the pub-lisher could not use the ‘‘suggested retail price’’ to determine the fair market value of the book for purposes of the enhanced deduc-tion. Thus, in general, the Committee intends that a bona fide pub-lished market price must be independently verifiable by reference to actual sales within the seven year period preceding the contribu-tion, and not to a publisher’s own price list.

As an illustration of the mechanics of calculating the enhanced deduction under the provision, a C corporation that made a quali-fied book contribution with a bona fide published market price of $10 and a basis of $4 could take a deduction of $8 (twice basis). If the taxpayer’s basis is $6 instead of $4, then the deduction is $10. Also, in such latter case, if the book’s bona fide market pub-lished market price was $5 at the time of the contribution but was $10 five years before the contribution, then the deduction is $10.

A qualified book contribution means a charitable contribution of books to: (1) an educational organization that normally maintains a regular faculty and curriculum and normally has a regularly en-rolled body of pupils or students in attendance at the place where its educational activities are regularly carried on; (2) a public li-brary; or (3) an organization described in section 501(c)(3) (except for private nonoperating foundations), that is organized primarily to make books available to the general public at no cost or to oper-ate a literacy program. The donee must: (1) use the property con-sistent with the donee’s exempt purpose; (2) not transfer the prop-erty in exchange for money, other property, or services; (3) provide the taxpayer a written statement that the donee’s use of the prop-erty will be consistent with such requirements and also that the books are suitable, in terms of currency, content, and quantity, for use in the donee’s educational programs and that the donee will use the books in such educational programs.

EFFECTIVE DATE



17

22 Sec. 170(e)(1). 23 Secs. 170(e)(4) and 170(e)(6).

E. EXPAND CHARITABLE CONTRIBUTION ALLOWED FOR SCIENTIFIC PROPERTY USED FOR RESEARCH AND FOR COMPUTER TECHNOLOGY AND EQUIPMENT


PRESENT LAW

In the case of a charitable contribution of inventory or other ordi-nary-income or short- term capital gain property, the amount of the charitable deduction generally is limited to the taxpayer’s basis in the property. In the case of a charitable contribution of tangible personal property, the deduction is limited to the taxpayer’s basis in such property if the use by the recipient charitable organization is unrelated to the organization’s tax-exempt purpose. In cases in-volving contributions to a private foundation (other than certain private operating foundations), the amount of the deduction is lim-ited to the taxpayer’s basis in the property.22

Under present law, a taxpayer’s deduction for charitable con-tributions of scientific property used for research and for contribu-tions of computer technology and equipment generally is limited to the taxpayer’s basis (typically, cost) in the property. However, cer-tain corporations may claim a deduction in excess of basis for a ‘‘qualified research contribution’’ or a ‘‘qualified computer contribu-tion.’’ 23 This enhanced deduction is equal to the lesser of (1) basis plus one-half of the item’s appreciated value (i.e., basis plus one half of fair market value minus basis) or (2) two times basis.

A qualified research contribution means a charitable contribution of inventory that is tangible personal property. The contribution must be to a qualified educational or scientific organization and be made not later than two years after construction of the property is substantially completed. The original use of the property must be by the donee, and be used substantially for research or experimen-tation, or for research training, in the U.S. in the physical or bio-logical sciences. The property must be scientific equipment or appa-ratus, constructed by the taxpayer, and may not be transferred by the donee in exchange for money, other property, or services. The donee must provide the taxpayer with a written statement rep-resenting that it will use the property in accordance with the condi-tions for the deduction. For purposes of the enhanced deduction, property is considered constructed by the taxpayer only if the cost of the parts used in the construction of the property (other than parts manufactured by the taxpayer or a related person) do not ex-ceed 50 percent of the taxpayer’s basis in the property.

A qualified computer contribution means a charitable contribu-tion of any computer technology or equipment, which meets stand-ards of functionality and suitability as established by the Secretary of the Treasury. The contribution must be to certain educational or-ganizations or public libraries and made not later than three years after the taxpayer acquired the property or, if the taxpayer con-structed the property, not later than the date construction of the


18

24 If the taxpayer constructed the property and reacquired such property, the contribution must be within three years of the date the original construction was substantially completed. Sec. 170(e)(6)(D)(i).

25 This requirement does not apply if the property was reacquired by the manufacturer and contributed. Sec. 170(e)(6)(D)(ii).

26 Sec. 170(e)(6)(C). 27 Secs. 170, 2055, and 2522, respectively.

property is substantially completed.24 The original use of the prop-erty must be by the donor or the donee,25 and in the case of the donee, must be used substantially for educational purposes related to the function or purpose of the donee. The property must fit pro-ductively into the donee’s education plan. The donee may not trans-fer the property in exchange for money, other property, or services, except for shipping, installation, and transfer costs. To determine whether property is constructed by the taxpayer, the rules applica-ble to qualified research contributions apply. Contributions may be made to private foundations under certain conditions.26

REASONS FOR CHANGE

The Committee believes that extension of the enhanced deduc-tion to include property assembled by the taxpayer will lead to in-creased charitable contributions of scientific property used for re-search and computer technology and equipment and will help to eliminate confusion in determining whether property is ‘‘con-structed’’ or ‘‘assembled’’ for purposes of claiming the enhanced de-duction.


Under the provision, property assembled by the taxpayer, in ad-dition to property constructed by the taxpayer, is eligible for either enhanced deduction. The Committee does not intend that old or used components assembled by the taxpayer into scientific property or computer technology or equipment are eligible for the enhanced deduction.

EFFECTIVE DATE


F. ENCOURAGE CONTRIBUTIONS OF CAPITAL GAIN REAL PROPERTY MADE FOR CONSERVATION PURPOSES


PRESENT LAW

Charitable contributions generally In general, a deduction is permitted for charitable contributions,

subject to certain limitations that depend on the type of taxpayer, the property contributed, and the donee organization. The amount of deduction generally equals the fair market value of the contrib-uted property on the date of the contribution. Charitable deduc-tions are provided for income, estate, and gift tax purposes.27

In general, in any taxable year, charitable contributions by a cor-poration are not deductible to the extent the aggregate contribu-tions exceed 10 percent of the corporation’s taxable income com-


19

puted without regard to net operating or capital loss carrybacks. For individuals, the amount deductible is a percentage of the tax-payer’s contribution base, which is the taxpayer’s adjusted gross in-come computed without regard to any net operating loss carryback. The applicable percentage of the contribution base varies depend-ing on the type of donee organization and property contributed. Cash contributions of an individual taxpayer to public charities, private operating foundations, and certain types of private nonop-erating foundations may not exceed 50 percent of the taxpayer’s contribution base. Cash contributions to private foundations and certain other charitable organizations generally may be deducted up to 30 percent of the taxpayer’s contribution base.

In general, a charitable deduction is not allowed for income, es-tate, or gift tax purposes if the donor transfers an interest in prop-erty to a charity while also either retaining an interest in that property or transferring an interest in that property to a non-charity for less than full and adequate consideration. Exceptions to this general rule are provided for, among other interests, remain-der interests in charitable remainder annuity trusts, charitable re-mainder unitrusts, and pooled income funds, present interests in the form of a guaranteed annuity or a fixed percentage of the an-nual value of the property, and qualified conservation contribu-tions.

Capital gain property Capital gain property means any capital asset or property used

in the taxpayer’s trade or business the sale of which at its fair mar-ket value, at the time of contribution, would have resulted in gain that would have been long-term capital gain. Contributions of cap-ital gain property to a qualified charity are deductible at fair mar-ket value within certain limitations. Contributions of capital gain property to charitable organizations described in section 170(b)(1)(A) (e.g., public charities, private foundations other than private non-operating foundations, and certain governmental units) generally are deductible up to 30 percent of the taxpayer’s con-tribution base. An individual may elect, however, to bring all these contributions of capital gain property for a taxable year within the 50-percent limitation category by reducing the amount of the con-tribution deduction by the amount of the appreciation in the capital gain property. Contributions of capital gain property to charitable organizations described in section 170(b)(1)(B) (e.g., private non-op-erating foundations) are deductible up to 20 percent of the tax-payer’s contribution base.

For purposes of determining whether a taxpayer’s aggregate charitable contributions in a taxable year exceed the applicable percentage limitation, contributions of capital gain property are taken into account after other charitable contributions. Contribu-tions of capital gain property that exceed the percentage limitation may be carried forward for five years.

Qualified conservation contributions Qualified conservation contributions are not subject to the ‘‘par-

tial interest’’ rule, which generally bars deductions for charitable contributions of partial interests in property. A qualified conserva-tion contribution is a contribution of a qualified real property inter-


20

est to a qualified organization exclusively for conservation pur-poses. A qualified real property interest is defined as: (1) the entire interest of the donor other than a qualified mineral interest; (2) a remainder interest; or (3) a restriction (granted in perpetuity) on the use that may be made of the real property. Qualified organiza-tions include certain governmental units, public charities that meet certain public support tests, and certain supporting organizations. Conservation purposes include: (1) the preservation of land areas for outdoor recreation by, or for the education of, the general pub-lic; (2) the protection of a relatively natural habitat of fish, wildlife, or plants, or similar ecosystem; (3) the preservation of open space (including farmland and forest land) where such preservation will yield a significant public benefit and is either for the scenic enjoy-ment of the general public or pursuant to a clearly delineated Fed-eral, State, or local governmental conservation policy; and (4) the preservation of an historically important land area or a certified historic structure.

Qualified conservation contributions of capital gain property are subject to the same limitations and carryover rules of other chari-table contributions of capital gain property.

REASONS FOR CHANGE

The Committee desires to provide additional incentives for chari-table donations of real property made for qualified conservation purposes. The Committee believes that increasing the percentage limitations applicable to qualified conservation contributions of real property, and increasing the carryover period applicable to such contributions from five to fifteen years, will increase donations made for qualified conservation purposes. The Committee also be-lieves that special incentives are required to encourage qualified conservation contributions of farm and ranch properties.


In general Under the provision, the 30-percent contribution base limitation

on contributions of capital gain property by individuals does not apply to qualified conservation contributions (as defined under present law). Thus, individuals may include the fair market value of any qualified conservation contribution of capital gain property in determining the amount of the charitable contributions subject to the 50-percent contribution base limitation.

Individuals are allowed to carryover any qualified conservation contributions that exceed the 50-percent limitation for up to 15 years. The 50-percent contribution base limitation applies first to contributions other than qualified conservation contributions and then to qualified conservation contributions. For example, assume an individual with a contribution base of $100 makes a qualified conservation contribution of property with a fair market value of $80 and makes other charitable contributions of $60. The indi-vidual is allowed a deduction of $50 in the current taxable year for the other contributions (50 percent of the $100 contribution base) and is allowed to carryover the excess $10 for up to 5 years. No current deduction is allowed for the qualified conservation con-


21

tribution but the entire $80 qualified conservation contribution may be carried forward for up to 15 years.

Farmers and ranchers In the case of an eligible farmer or rancher, a qualified conserva-

tion contribution is allowable up to 100 percent of the taxpayer’s contribution base (after taking into account other charitable con-tributions). This rule applies both to individuals and corporations. In addition, corporate (as well as non-corporate) eligible farmers and ranchers are allowed to carryover any excess qualified con-servation contributions for up to 15 years. The 100-percent con-tribution base limitation applies first to contributions other than qualified conservation contributions (to the extent allowable under other percentage limitations) and then to qualified conservation contributions. For example, assume an individual farmer or ranch-er with a contribution base of $100 makes a qualified conservation contribution of property with a fair market value of $80 and makes other charitable contributions of $60. The individual is allowed a deduction of $50 in the current taxable year for the other contribu-tions (50 percent of the $100 contribution base) and is allowed to carryover the excess $10 for up to 5 years. The individual is also allowed a deduction of $50 in the current taxable year for the qualified charitable contribution (the amount of the remaining con-tribution base). The remaining $30 qualified conservation contribu-tion may be carried forward for up to 15 years.

For this purpose, an eligible farmer or rancher means a taxpayer (other than a publicly traded C corporation) whose gross income from the trade of business of farming is at least 51 percent of the taxpayer’s gross income for the taxable year.

EFFECTIVE DATE

The provision is effective for contributions made in taxable years beginning after December 31, 2002.

G. EXCLUSION OF 25 PERCENT OF CAPITAL GAIN FOR CERTAIN SALES MADE FOR QUALIFYING CONSERVATION PURPOSES

(Sec. 107 of the bill and new sec. 121A of the Code)

PRESENT LAW

Sales of capital gain property Gain from the sale or exchange of land held more than one year

generally is treated as long-term capital gain. Generally, the net capital gain of an individual (i.e., long-term capital gain less short-term capital loss) is subject to a maximum tax rate of 20 percent.

Charitable contributions of capital gain property for conservation purposes

Special rules apply to charitable contributions of qualified con-servation contributions. Qualified conservation contributions are not subject to the ‘‘partial interest’’ rule, which generally bars de-ductions for charitable contributions of partial interests in prop-erty. A qualified conservation contribution is a contribution of a qualified real property interest to a qualified organization exclu-sively for conservation purposes. A qualified real property interest


22

28 Ltr. Rul. 8626029. 29 Treas. Reg. sec. 1.170A–14(c)(2). 30 Id.

is defined as: (1) the entire interest of the donor other than a quali-fied mineral interest; (2) a remainder interest; or (3) a restriction (granted in perpetuity) on the use that may be made of the real property. Charitable contributions of interests that constitute the taxpayer’s entire interest in the property are not regarded as quali-fied real property interests within the meaning of section 170(h),28 but instead are subject to the general rules applicable to charitable contributions of entire interests of the taxpayer. Qualified organiza-tions include certain governmental units, public charities that meet certain public support tests, and certain supporting organizations. Conservation purposes include: (1) the preservation of land areas for outdoor recreation by, or for the education of, the general pub-lic; (2) the protection of a relatively natural habitat of fish, wildlife, or plants, or similar ecosystem; (3) the preservation of open space (including farmland and forest land) where such preservation will yield a significant public benefit and is either for the scenic enjoy-ment of the general public or pursuant to a clearly delineated Fed-eral, State, or local governmental conservation policy; and (4) the preservation of an historically important land area or a certified historic structure.

Treasury regulations provide that a deduction for a qualified con-servation contribution is allowed only if the donor prohibits in the instrument of conveyance the donee from subsequently transferring the qualified real property interest, whether or not for consider-ation, unless the donee organization, as a condition of the subse-quent transfer, requires that the conservation purpose which the contribution was originally intended to advance continues to be car-ried out.29 Moreover, subsequent transfers of such interests are re-stricted to organizations that are qualified conservation organiza-tions.30

REASONS FOR CHANGE

Some landowners may want their land to be protected for con-servation purposes but cannot afford simply to donate either the land or an easement on the land, especially if the land is the land-owner’s primary asset. The Committee desires to encourage the sale of appreciated, environmentally sensitive land and real prop-erty interests in land or water, as well as controlling stock inter-ests in certain land corporations, to qualified conservation organi-zations and governments, thus achieving conservation goals through voluntary sales of property. The Committee believes that providing taxpayers a partial exclusion of capital gain derived from the voluntary sale of properties for conservation purposes will in-crease the number of properties dedicated to conservation purposes. The Committee desires to facilitate the transfers of properties to conservation organizations in a manner that will, to the extent practicable, preserve the value of the properties once they are ac-quired by the conservation organizations, while providing safe-guards designed to ensure the protection of the conservation pur-poses for which the properties are intended to be used.


23

31 The exclusion is mandatory if all of the requirements of the provision are satisfied, and a taxpayer need not file an election to take advantage of the exclusion. A taxpayer who transfers qualifying property to a qualified organization may opt out of the 25-percent exclusion by choos-ing not to satisfy one or more of the provision’s requirements without having to file a formal election with the Secretary, such as by failing to obtain the requisite letter of intent from the qualified organization.


In general The bill provides a 25–percent exclusion from gross income of

long-term capital gain from the qualifying sale or exchange of land, or an interest in land or water rights, provided that the land or in-terest in land or water rights constitutes an interest in real prop-erty that has been held by the taxpayer or the taxpayer’s family at all times during the five years preceding the date of sale. The qualifying sale must be made to a qualified organization that in-tends that the acquired property be used for qualified conservation purposes in perpetuity.31

Qualifying interests The exclusion applies only to sales or exchanges of real property

interests in land or water rights that constitute the entire interest of the taxpayer in such land or water rights, or that constitute qualified real property interests as defined in section 170(h), spe-cifically: (1) the entire interest of the taxpayer other than a quali-fied mineral interest; (2) a remainder interest; or (3) a restriction (granted in perpetuity) on the use which may be made of the real property. Partial interests in property that are not the entire inter-est of the taxpayer or a qualified real property interest do not qual-ify for the exclusion. For example, a taxpayer who owns land and related mineral rights but who sells only the mineral rights is not eligible for the exclusion. However, a taxpayer who owns only min-eral rights is eligible for the 25–percent exclusion if the taxpayersells his or her entire interest in the mineral rights and satisfies the other requirements of the provision.

Generally, an undivided interest that constitutes the taxpayer’s entire interest in the property is eligible for the exclusion. A partial interest (for example, an undivided interest) that constitutes the taxpayer’s entire interest in the property, however, does not qualify for the exclusion if the property in which such partial interest ex-ists was divided in an attempt to avoid the partial interest rules. The Committee intends that the partial interest rules contained in Treasury Regulations section 1.170A–7(a)(2)(i) and generally appli-cable to contributions of partial interests be applied similarly for purposes of this provision. For example, if a taxpayer transfers an undivided interest in property to a spouse and immediately there-after sells the remaining undivided interest to a qualified organiza-tion, the exclusion will not apply to the taxpayer’s sale to the quali-fied organization.

Under the provision, the exclusion is available for long-term cap-ital gain from certain sales or exchanges of stock in a C corporation if the qualified organization ultimately obtains a controlling stock interest (generally a stock interest that provides the qualified orga-nization at least 90 percent of the total voting power and total value of the corporation’s stock) and if at least 90 percent of the fair market value of the C corporation’s assets at the time of the


24

32 The Committee intends that soil and water conservation expenditures in the nature of those described in section 175, determined without regard to whether the taxpayer is engaged in a farming business and that the land be used for farming, generally be treated as furthering a qualified conservation purpose.

33 The Committee intends that the taxpayer be required to use this gain allocation rule unless the taxpayer has adequate records to substantiate the adjusted basis and fair market value to support a separate calculation.

sale or exchange consists of land or water rights, or interests in land or water rights, that were held by the corporation at all times during the five years preceding the sale. Stock in a corporation will not qualify if at the time of the sale or exchange the fair market value of water rights and infrastructure relating to the delivery of water constitutes more than 50 percent of the fair market value of all of the corporation’s assets. Only a stock interest held by the tax-payer or the taxpayer’s family at all times during the five years preceding the sale qualifies for the 25–percent exclusion. The Com-mittee intends that in appropriate circumstances a controlling stock interest may be acquired by the qualified organization from multiple persons in multiple transactions, and authorizes the Sec-retary to issue guidance regarding the availability of the exclusion in such cases.

Qualifying gain The exclusion applies only to long-term capital gain. Gain treated

as ordinary income, such as under depreciation recapture provi-sions, is not eligible for the exclusion. Gain attributable to certain improvements, such as buildings or structures that do not further a qualified conservation purpose (‘‘disqualified improvements’’), also does not qualify for the exclusion.32 The bill provides that the max-imum amount of gain that may be excluded by a shareholder in the case of a sale or exchange of a controlling stock interest is 25 per-cent of the shareholder’s proportionate share of the C corporation’s underlying gain attributable to qualifying land, water rights, or in-terests therein held by the C corporation.

Consistent with present law, the determination of gain or loss is to be calculated on an asset-by-asset basis whenever that is re-quired for other purposes of the Code (such as for purposes of sec-tion 1245 or section 1250). To minimize administrative complexity and assist taxpayers in the preparation of their returns, the Com-mittee intends that in those cases where the Code does not other-wise require a separate determination of gain or loss for the dis-qualified improvement, the gain allocable to the disqualified im-provement shall be determined by reference to the fair market value of the disqualified improvement relative to the fair market value of all assets for which a gain or loss determination is not oth-erwise required by the Code.33

For example, if a taxpayer sells a qualifying land interest with a fair market value of $100 and a basis of $30, that includes a building or structure that does not further a conservation purpose (a disqualified improvement) and that has a fair market value of $40, the taxpayer must determine the portion of the gain that is attributable to the eligible land and to the disqualified improve-ment. If determination of gain or loss on the sale of the improve-ment is required for other purposes of the Code, then the gain or loss determined for those purposes governs, and the taxpayer must determine his or her basis of the disqualified improvement (in this


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34 A sale or exchange made prior to the issuance of an order, but that is the result of the threat of condemnation or eminent domain, may qualify for the exclusion.

case, assumed to be zero), with the result that the $40 gain on the disqualified improvement is not eligible for the 25–percent exclu-sion and the gain of $30 on the land is eligible for the 25–percent exclusion. On the other hand, if the determination of gain or loss on the sale of the improvement is not required for other purposes of the Code, then the Committee intends that the taxpayer allocate the aggregate gain of $70 attributable to the land and the disquali-fied improvement between the land and the improvement on the basis of their respective fair market values (i.e., 40 percent to the improvement and 60 percent to the land). Under this gain alloca-tion rule, the $28 of gain allocable to the improvement is not eligi-ble for the 25–percent exclusion, and the $42 of gain allocable to the land qualifies for the 25-percent exclusion.

Eligible sales An eligible sale is a sale or exchange (excluding a transfer made

by order of condemnation or eminent domain) 34 that may be made only to a qualified organization, defined as a Federal, State, or local government, or an agency or department thereof or a section 501(c)(3) organization that is organized and operated primarily to meet a qualified conservation purpose. In addition, to be an eligible sale, the organization acquiring the property interest must provide the taxpayer with a letter stating that the intent of such organiza-tion in acquiring the property is to further a qualified conservation purpose and that any subsequent transfer of the acquired interest will be to a qualified organization and made to protect the con-servation purpose in perpetuity. A qualified conservation purpose is: (1) the preservation of land areas for outdoor recreation by, or the education of, the general public; (2) the protection of a rel-atively natural habitat of fish, wildlife, or plants, or similar eco-system; or (3) the preservation of open space (including farmland and forest land) where the preservation is for the scenic enjoyment of the general public or pursuant to a clearly delineated Federal, State, or local governmental conservation policy and will yield a significant public benefit.

Protection of conservation purposes The bill provides for the imposition of penalty excise taxes in ap-

propriate cases where a qualified organization fails to take steps consistent with the protection of conservation purposes. Because the penalty taxes are imposed on an organization that fails to pro-tect the conservation purpose, and do not serve to encumber the property in the same manner as a restriction contained in an in-strument of conveyance, the Committee believes that the penalty taxes will adequately protect conservation purposes without de-creasing the value of the property in the hands of the conservation organizations.

If ownership or possession of the property is transferred by a qualified organization other than to another qualified organization, or a legal restriction contained in an instrument of conveyance that protects the qualified conservation purpose is removed, then: (1) a 20-percent excise tax applies to the proceeds or fair market value


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of the property, (2) any realized gain or income is subject to an ad-ditional excise tax imposed at the highest income tax rate applica-ble to C corporations, and (3) any otherwise applicable non-recogni-tion provisions of the Code shall not apply to the transferor. The Committee intends that the excise taxes apply to all cases involv-ing the transfer of ownership or possession of the property to a transferee that is not a qualified organization unless the transfer-ring qualified organization demonstrates to the satisfaction of the Secretary that qualified conservation purposes will be protected in perpetuity. In the case of a removal of a legal restriction contained in an instrument of conveyance, the qualified organization must demonstrate to the satisfaction of the Secretary that a later unex-pected change in the conditions surrounding the property makes retaining the conservation restriction impossible or impractical and that any proceeds derived from the removal of the restriction will be used to further qualified conservation purposes. The Committee authorizes the Secretary to provide guidance to identify appro-priate cases where transfers to persons other than qualified organi-zations are regarded as protecting a conservation purpose in per-petuity. The Committee intends, for example, that a qualified orga-nization may acquire a fee simple interest in real property operated as a farm and then transfer, without imposition of the penalty taxes, the real property subject to a conservation easement that constitutes a qualified real property interest if, in a recorded in-strument of conveyance, the transferor prohibits the transferee from subsequently transferring the real property unless the trans-feree, as a condition of the subsequent transfer, requires that the qualified conservation purpose of preserving the property as open space farmland will continue to be carried out.

In the case of a transfer by a qualified organization to another qualified organization, the transferee must provide the transferor at the time of the transfer a letter stating that the intent of the transferee is to further a qualified conservation purpose and that any subsequent transfer of the acquired interest will be made to protect the conservation purpose in perpetuity, and the transferee becomes subject to the excise tax provisions for subsequent trans-fers. The Committee intends that in the case of a sale or exchange of stock of a C corporation in which a qualified organization ac-quires a controlling stock interest, all of the stock of such corpora-tion acquired by the qualified organization (including any stock which did not qualify for the exclusion), as well as the property held by such C corporation, becomes subject to the penalty tax pro-visions.

The bill provides that the Secretary may require such reporting as may be necessary or appropriate to further the purpose that any conservation use be in perpetuity.

Relationship with other provisions In the case of an individual, the exclusion applies both for pur-

poses of the regular tax and the alternative minimum tax. In the case of a corporation, the present-law alternative minimum tax pro-visions apply without modification.

If a taxpayer sells a real property interest to a qualified organi-zation for less than the property’s fair market value, the amount of any charitable contribution deduction is determined in accord-


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35 Sec. 1011(b) and Treas. Reg. sec. 1.1011–2.

ance with the bargain sale rules,35 and the taxpayer shall not fail to qualify for a contribution deduction under those rules solely be-cause the taxpayer derives a tax benefit from the partial exclusion of long-term capital gain from the sale. For example, if a taxpayer sells qualifying land with a fair market value of $100 and an ad-justed basis of $10 to a qualified organization for a sales price of $95 (or alternatively, for a sale price of $50), the taxpayer’s basis of $10 shall be allocated between the sale and the contribution components of the transfer under the bargain sale rules, and the tax savings resulting from the 25-percent exclusion of long-term capital gain on the sale will not reduce the portion of the transfer treated as a charitable contribution under the bargain sale rules. The present-law requirements applicable to the charitable contribu-tion component of the transfer, including, for example, the record-keeping, substantiation, and appraisal provisions of Treasury Regu-lations section 1.170A–13, must be satisfied.

EFFECTIVE DATE

The provision is effective for sales or exchanges occurring after December 31, 2003, in taxable years ending after such date.

H. COST SHARING PAYMENTS UNDER THE PARTNERS FOR FISH AND WILDLIFE PROGRAM


PRESENT LAW

Under present law, gross income does not include the excludable portion of payments made to taxpayers by federal and state govern-ments for a share of the cost of improvements to property under certain conservation programs. These programs include payments received under (1) the rural clean water program authorized by sec-tion 208(j) of the Federal Water Pollution Control Act, (2) the rural abandoned mine program authorized by section 406 of the Surface Mining Control and Reclamation Act of 1977, (3) the water bank program authorized by the Water Bank Act, (4) the emergency con-servation measures program authorized by title IV of the Agricul-tural Credit Act of 1978, (5) the agriculture conservation program authorized by the Soil Conservation and Domestic Allotment Act, (6) the great plains conservation program authorized by section 16 of the Soil Conservation and Domestic Policy Act, (7) the resource conservation and development program authorized by the Bankhead-Jones Farm Tenant Act and by the Soil Conservation and Domestic Allotment Act, (8) the forestry incentives program authorized by section 4 of the Cooperative Forestry Assistance Act of 1978, (9) any small watershed program administered by the Sec-retary of Agriculture which is determined by the Secretary of the Treasury or his delegate to be substantially similar to the type of programs described in items (1) through (8), and (10) any program of a State, possession of the United States, a political subdivision of any of the foregoing, or the District of Columbia under which payments are made to individuals primarily for the purpose of con-


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36 Sec. 1366(a)(1)(A). 37 Sec. 1367(a)(2)(B).

serving soil, protecting or restoring the environment, improving for-ests, or providing a habitat for wildlife.

REASONS FOR CHANGE

The Committee believes that payments received by taxpayers under the Partners for Fish and Wildlife Program are similar to payments made under other government programs that are exclud-able from gross income under present law. Accordingly, the Com-mittee believes it is appropriate to extend the present-law exclu-sion to payments under this program.


The provision expands the types of qualified cost-sharing pay-ments to include payments under the Partners for Fish and Wild-life Program.

EFFECTIVE DATE

The provision applies to taxable years beginning after December 31, 2002.

I. BASIS ADJUSTMENT TO STOCK OF S CORPORATION CONTRIBUTING PROPERTY


PRESENT LAW

Under present law, if an S corporation contributes money or other property to a charity, each shareholder takes into account the shareholder’s pro rata share of the contribution in determining its own income tax liability.36 A shareholder of an S corporation re-duces the basis in the stock of the S corporation by the amount of the charitable contribution that flows through to the shareholder.37

REASONS FOR CHANGE

Under present law, if an S corporation makes a charitable con-tribution of appreciated property, the shareholder may be taxed on an amount equal to the appreciation in the contributed property when the S corporation stock is sold. Thus, under present law, a charitable contribution of appreciated property made by an S cor-poration receives less favorable tax treatment than other contribu-tions of appreciated property.

The Committee wishes to preserve the benefit of providing a charitable contribution deduction for contributions of property by an S corporation with a fair market value in excess of its adjusted basis. Thus, the bill provides that the basis adjustment to the stock of an S corporation for charitable contributions made by the cor-poration will be in an amount equal to the shareholder’s pro rata share of the adjusted basis of the property contributed. This adjust-ment will prevent the later recognition of gain attributable to the appreciation in the contributed property on the disposition of the S corporation stock.


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38 See Rev. Rul. 96–11 (1996–1 C.B. 140) for a rule reaching a similar result in the case of charitable contributions madee by a partnership.

39 Sec. 170(e)(1). 40 Sec. 170(e)(1)(B)(ii). 41 Sec. 170(f)(3).


The provision provides that the amount of a shareholder’s basis reduction in the stock of an S corporation by reason of a charitable contribution made by the corporation will be equal to the share-holder’s pro rata share of the adjusted basis of the contributed property.38

Thus, for example, assume an S corporation with one individual shareholder makes a charitable contribution of stock with a basis of $200 and a fair market value of $500. The shareholder will be treated as having made a $500 charitable contribution (or a lesser amount if the special rules of section 170(e) apply), and will reduce the basis of the S corporation stock by $200.

EFFECTIVE DATE

The provision applies to contributions made in taxable years be-ginning after December 31, 2002.

J. ENHANCED DEDUCTION FOR CHARITABLE CONTRIBUTION OF LITERARY, MUSICAL, ARTISTIC, AND SCHOLARLY COMPOSITIONS


PRESENT LAW

In the case of a charitable contribution of inventory or other ordi-nary-income or short- term capital gain property, the amount of the deduction generally is limited to the taxpayer’s basis in the prop-erty.39 In the case of a charitable contribution of tangible personal property, the deduction is limited to the taxpayer’s basis in such property if the use by the recipient charitable organization is unre-lated to the organization’s tax-exempt purpose. In cases involving contributions of tangible personal property to a private foundation (other than certain private foundations),40 the amount of the de-duction is limited to the taxpayer’s basis in the property.

Under present law, charitable contributions of literary, musical, and artistic compositions are considered ordinary income property and a taxpayer’s deduction of such property is limited to the tax-payer’s basis (typically, cost) in the property. To be eligible for the deduction, the contribution must be of an undivided portion of the donor’s entire interest in the property.41 For purposes of the chari-table income tax deduction, the copyright and the work in which the copyright is embodied are not treated as separate property in-terests. Accordingly, if a donor owns a work of art and the copy-right to the work of art, a gift of the artwork without the copyright or the copyright without the artwork will constitute a gift of a ‘‘par-tial interest’’ and will not qualify for the income tax charitable de-duction.

REASONS FOR CHANGE

The Committee believes that it is appropriate to provide an en-hanced deduction for charitable contributions of certain literary,


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musical, artistic, and scholarly compositions created by the per-sonal efforts of the donor. In many cases, such works have a low basis, and because present law generally limits the deduction for such contributions to basis, the creators of literary, musical, artis-tic, and scholarly compositions do not have an appropriate incen-tive to contribute their works to charity. In addition, the Com-mittee believes that the present-law rule that a charitable con-tribution deduction generally is not available for contributions of less than the taxpayer’s entire property interest is an inappropriate disincentive for contributions of such works.


The bill provides that a deduction for ‘‘qualified artistic chari-table contributions’’ generally is increased from the value under present law (generally, basis) to the fair market value of the prop-erty contributed, measured at the time of the contribution. How-ever, the amount of the increase of the deduction provided by the provision may not exceed the amount of the donor’s adjusted gross income for the taxable year attributable to: (1) income from the sale or use of property created by the personal efforts of the donor that is of the same type as the donated property; and (2) income from teaching, lecturing, performing, or similar activities with re-spect to such property. In addition, the increase to the present-law deduction provided by the provision may not be carried over and deducted in other taxable years.

The provision defines a qualified artistic charitable contribution to mean a charitable contribution of any literary, musical, artistic, or scholarly composition, or similar property, or the copyright thereon (or both) that meets certain requirements. First, the con-tributed property must have been created by the personal efforts of the donor at least 18 months prior to the date of contribution. The Committee intends that ‘‘personal efforts’’ shall be defined by reference to Treasury regulations section 1.1221–1(c). Second, the donor must obtain a qualified appraisal of the contributed property, a copy of which is required to be attached to the donor’s income tax return for the taxable year in which such contribution is made. The appraisal must include evidence of the extent (if any) to which property created by the personal efforts of the taxpayer and of the same type as the donated property is or has been owned, main-tained, and displayed by certain charitable organizations and sold to or exchanged by persons other than the taxpayer, donee, or any related person. Third, the contribution must be made to a public charity or to certain limited types of private foundations. Finally, the use of donated property by the recipient organization must be related to the organization’s charitable purpose or function, and the donor must receive a written statement from the organization verifying such use.

Under the provision, the tangible property and the copyright on such property are treated as separate properties for purposes of the ‘‘partial interest’’ rule; thus, a gift of artwork without the copyright or a copyright without the artwork does not constitute a gift of a partial interest and is deductible. Contributions of letters, memo-randa, or similar property that are written, prepared, or produced by or for an individual while the individual is an officer or em-ployee of any person (including a government agency or instrumen-


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42 Sec. 6103(a). A ‘‘return’’ includes any tax or information return, declaration of estimated tax, or claim for refund required by, or provided for, or permitted under the provisions of the Code, which is filed with the IRS. Sec. 6103(b)(1). ‘‘Return’’ also includes any amendment or sup-plement to the filed return. Sec. 6103(b)(1). ‘‘Return information’’ is defined broadly to include any data received by, recorded by, prepared by, furnished to, or collected by the Secretary with respect to a return or with respect to the determination of the existence, or possible existence, of liability (or the amount thereof) of any person for any tax, penalty, interest, fine, forfeiture, or other imposition, or offense under the Code. The term ‘‘return information’’ does not include data in a form that cannot be associated with, or otherwise identify, directly or indirectly, a par-ticular taxpayer. Sec. 6103(b)(2).

43 Sec. 6110(l)(1). 44 Section 6104(a)(1)(A) provides that ‘‘any papers submitted in support of’’ an application for

tax-exempt status must be available for inspection. Treasury regulations limit the definition of Continued

tality) do not qualify for a fair market value deduction unless the contributed property is entirely personal.

EFFECTIVE DATE

The deduction for qualified artistic charitable contributions ap-plies to contributions made after December 31, 2002, in taxable years ending after such date.

Title II. Disclosure of Information Relating to Tax-Exempt Organizations

A. DISCLOSURE OF WRITTEN DETERMINATIONS


PRESENT LAW

In general Three provisions of present law govern the disclosure of informa-

tion relating to tax-exempt organizations. First, section 6103 pro-vides a general rule that tax returns and return information gen-erally are not subject to public disclosure.42 Second, in order to allow the public to scrutinize the activities of tax-exempt organiza-tions, section 6104 grants an exception to the confidentiality rule of section 6103 for certain categories of tax-exempt organization documents and information. Section 6104 permits the release in unredacted form of approved applications for tax-exempt status, certain related documents, and annual information returns filed by tax-exempt organizations. As a general rule, to the extent section 6104 specifically provides for the disclosure of tax-exempt organiza-tion information, other disclosure provisions do not apply. If tax-ex-empt organization information does not come within the scope of section 6104, other disclosure provisions will govern whether the information may be disclosed. Third, section 6110 provides that written determinations by the IRS and related background file doc-uments generally are open to public inspection in redacted form. Section 6110 does not apply to any matter to which section 6104 applies.43

Disclosure of applications for recognition of tax exemption and an-nual information returns

Under present law, tax-exempt organizations are required to make a copy of their application for recognition of tax-exempt sta-tus (and certain related documents) 44 and their annual information


32

supporting documents to papers submitted by the organization. Treas. Reg. sec. 301.6104(a)–1(e).

45 Treas. Reg. sec. 301.6104(d)–1(b)(3)(iii)(A). 46 Sec. 6104(a)(1)(D). In the case of a pension plan, information may be withheld if it would

identify any particular individual covered under the plan. Id.47 Treas. Reg. sec. 301.6104(a)–5(a)(1). 48 Sec. 6110(a). 49 A ruling is a written statement issued by the National Office to a taxpayer or his or her

authorized representative. Treas. Reg. sec. 301.6110–2(d). It generally recites the relevant facts, sets forth the applicable provisions of law, and shows the application of the law to the facts. Treas. Reg. sec. 301.6110–2(d).

50 A district director issues a ‘‘determination letter’’ in response to a written inquiry from an individual or organization that applies principles and precedents previously announced by the IRS National Office to the particular facts involved. Treas. Reg. sec. 301.6110–2(e).

51 A ‘‘technical advice memorandum’’ is a written statement issued by the IRS National Office to a district director in connection with the examination of a taxpayer’s return or consideration of a taxpayer’s claim for refund or credit. Treas. Reg. sec. 301.6110–2(f). Generally, a technical advice memorandum states the relevant facts, sets forth the applicable law, and states a legal conclusion. Treas. Reg. sec. 301.6110–2(f).

52 Sec. 6110(b)(1). Any IRS National Office component of the Office of Chief Counsel can issue Chief Counsel advice. The IRS National Office component issues the advice to IRS field or serv-ice center employees, or to regional or district employees of Chief Counsel. Sec. 6110(i)(A)(i). The definition of Chief Counsel advice does not encompass advice issued from one IRS National Of-fice component of the Office of Chief Counsel to another. The advice by definition conveys: (1) a legal interpretation of a revenue provision; (2) the IRS or Chief Counsel position or policy con-cerning a revenue provision; or (3) a legal interpretation of any law (Federal, State, or foreign) relating to the assessment or collection of liability under a revenue provision. Sec. 6110(i)(A)(ii).

53 Sec. 6103(b)(2)(D); sec. 6110(b)(1)(B). 54 Sec. 6110(b)(2). Communications between the IRS and the Department of Justice relating

to a pending civil or criminal case are not considered background file documents.

return (Form 990 or Form 990–PF) available for public inspection. Organizations are not required to disclose an application for tax ex-emption filed by the organization unless the IRS responded favor-ably to the application.45 Charitable organizations that are not classified as private foundations are not required to disclose the names of donors to the organization.

The Secretary may withhold disclosure of certain information de-scribed in an organization’s application for tax-exempt status if dis-closure would: (1) divulge a trade secret, patent, process, style of work, or apparatus of the organization, and the Secretary deter-mines that such disclosure would harm the organization; or (2) that the Secretary determines would harm the national defense.46 The organization must apply to the Commissioner for a determination that the disclosure would violate one of these criteria. The organi-zation will be given 15 days to contest an adverse determination before the information is made available for public inspection.47

Disclosure of written determinations Section 6110 provides that the text of any written determination

by the IRS and related background file document is open to public inspection.48 The term ‘‘written determination’’ means a ruling,49 determination letter,50 technical advice memorandum,51 or Chief Counsel advice.52 Closing agreements, which are final and conclu-sive written agreements entered into by the IRS and a taxpayer in order to settle the taxpayer’s tax liability with respect to a taxable year, do not constitute written determinations.53 A background file document includes the request for a written determination, any written material submitted by the taxpayer in support of the re-quest, and any communications between the IRS and other persons in connection with the written determination received before issuance of the written determination.54

A background file document is available upon written request to any person requesting a copy of the related written determina-


33

55 Sec. 6110(e). 56 Sec. 6110(c) provides the following exemptions from disclosure: (1) the names, addresses,

and other identifying details of the person to whom the written determination pertains and of any other person, other than a person with respect to whom a notation is made under subsection (d)(1) (relating to third party contacts), identified in the written determination or any back-ground file document; (2) information specifically authorized under criteria established by an Executive order to be kept secret in the interest of national defense or foreign policy, and which is in fact properly classified pursuant to such Executive order; (3) information specifically ex-empted from disclosure by any statute (other than this title) which is applicable to the Internal Revenue Service; (4) trade secrets and commercial or financial information obtained from a per-son and privileged or confidential; (5) information the disclosure of which would constitute a clearly unwarranted invasion of personal privacy; (6) information contained in or related to ex-amination, operating, or condition reports prepared by, or on behalf of, or for use of an agency responsible for the regulation or supervision of financial institutions; and (7) geological and geo-physical information and data, including maps, concerning wells.

57 Sec. 6110(l)(1); Treas. Reg. sec. 301.6110–1(a). 58 Treas. Reg. sec. 301.6110–1(a). 58 Treas. Reg. sec. 301.6104(a)–1(i).

tion.55 Before releasing any written determination or background file document, the IRS must delete identifying details of the person about whom the written determination pertains and certain other information.56 With respect to tax-exempt organizations, disclosure under section 6110 is limited to letters and rulings unrelated to an organization’s tax-exempt status.57

The application of section 6110 to guidance relating to tax-ex-empt organizations is limited. Section 6110(l)(1) provides, ‘‘this sec-tion shall not apply to any matter to which section 6104 applies.’’ The regulations under section 6110 clarify which matters are with-in the ambit of section 6104 and, therefore, are not subject to dis-closure under section 6110:

[a]ny application filed with the Internal Revenue Service with respect to the qualification or exempt status of an or-ganization * * *; any document issued by the Internal Rev-enue Service in which the qualification or exempt status of an organization is * * * granted, denied or revoked or the portion of any document in which technical advice with re-spect thereto is given to a district director; * * * the por-tion of any document issued by the Internal Revenue Serv-ice in which is discussed the effect on the qualification or exempt status of an organization * * * of proposed trans-actions by such organization * * * ; and any document issued by the Internal Revenue Service in which is dis-cussed the qualification or status of a [private foundation or private operating foundation].58

In addition, the regulations under section 6104 provide that some determination letters and other documents relating to tax exemp-tion that are not open to public inspection under section 6104(a)(1)(A) are nevertheless ‘‘within the ambit’’ of section 6104 for purposes of the disclosure provisions of section 6110.59 The reg-ulation explains that the following documents are, therefore, not available for public inspection under either section 6104 or 6110:

(1) Unfavorable rulings or determination letters issued in re-sponse to applications for tax exemption;

(2) Rulings or determination letters revoking or modifying a favorable determination letter;

(3) Technical advice memoranda relating to a disapproved application for tax exemption or the revocation or modification of a favorable determination letter;


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60 Id.

(4) Any letter or document filed with or issued by the IRS relating to whether a proposed or accomplished transaction is a prohibited transaction under section 503;

(5) Any letter or document filed with or issued by the IRS relating to an organization’s status as a private foundation or private operating foundation, unless the letter or document re-lates to the organization’s application for tax exemption; and

(6) Any other letter or document filed with or issued by the IRS which, although it relates to an organization’s tax exempt status as an organization described in section 501(c), does not relate to that organization’s application for tax exemption.60

The effect of these limitations is that written determinations re-lating to exempt status issues are not released, even in redacted form. The IRS does, however, release written determinations issued to tax-exempt organizations that include issues that clearly are not within the ambit of section 6104, such as the application of the un-related business income tax to a particular proposed transaction.

REASONS FOR CHANGE

The Committee believes that present law inappropriately pro-tects from disclosure certain written determinations and back-ground file documents that relate to the tax-exempt status of orga-nizations described in section 501(c) and (d). The Committee be-lieves that written determinations and background file documents that ordinarily would be disclosed under section 6110 but for the nondisclosure provided by section 6104 should be disclosed in re-dacted form, and that such disclosure will provide additional guid-ance to taxpayers as to the views of the IRS on certain issues.


The provision requires disclosure in redacted form of written de-terminations and related background file documents, as defined in section 6110, relating to the tax-exempt status of an organization described in section 501(c) or (d) that are not required to be dis-closed by section 6104(a)(1)(A) but that are within the scope of sec-tion 6104 and thus are not presently disclosed. The provision pro-vides that such written determinations and related background file documents shall be disclosed under the provisions of section 6110. Documents that are within the scope of section 6104 and that are not presently disclosed include: (1) unfavorable rulings or deter-mination letters issued in response to applications for tax exemp-tion; (2) rulings or determination letters revoking or modifying a favorable determination letter; (3) technical advice memoranda re-lating to a disapproved application for tax exemption or the revoca-tion or modification of a favorable determination letter; (4) any let-ter or document filed with or issued by the IRS relating to whether a proposed or accomplished transaction is a prohibited transaction under section 503; (5) any letter or document filed with or issued by the IRS relating to an organization’s status as a private founda-tion or private operating foundation, unless the letter or document relates to the organization’s application for tax exemption; and (6) any other letter or document filed with or issued by the IRS which, although it relates to an organization’s tax exempt status as an or-


35

61 Sec. 6033(a). See, e.g., Form 990—Return of Organization Exempt From Income Tax. An or-ganization that is required to file Form 990, but that has gross receipts of less than $100,000 during its taxable year, and total assets of less than $250,000 at the end of its taxable year, may file Form 990–EZ instead of Form 990. Private foundations are required to file Form 990–PF rather than Form 990.

62 The IRS requires disclosure of an organization’s Internet web site address on Forms 990 and 990–EZ.

63 The staff of the Joint Committee on Taxation recommended the adoption of this provision. Joint Committee on Taxation, Study of Present-Law Taxpayer Confidentiality and Disclosure Provisions as Required by Section 3802 of the Internal Revenue Service Restructuring and Re-form Act of 1998, Volume II: Study of Disclosure Provisions Relating to Tax-Exempt Organiza-tions (JCS–1–00), January 28, 2000 at 96–97.

ganization described in section 501(c) or (d), does not relate to that organization’s application for tax exemption. To the extent section 6110 applies to such documents, they would be disclosed under the provision.

EFFECTIVE DATE

The provision is effective for written determinations issued after December 31, 2002.

B. DISCLOSURE OF INTERNET WEB SITE AND NAME UNDER WHICH ORGANIZATION DOES BUSINESS


PRESENT LAW

Most types of tax-exempt organizations are required to file annu-ally an information return.61 The Internal Revenue Code does not require an exempt organization to furnish on the applicable infor-mation return any name under which the organization operates or does business, if such name differs from the legal name of the orga-nization, or the organization’s Internet web site address, if any.62

REASONS FOR CHANGE

Some tax-exempt organizations do business and solicit contribu-tions under a name that is different from the organization’s legal name. This can cause confusion to individuals and others seeking information about the organization. Further, although much infor-mation regarding the operations and activities of tax-exempt orga-nizations is available on the Internet web sites of such organiza-tions, some members of the public might experience difficulties ob-taining access to an organization’s web site if they do not know the organization’s web site address. The Committee believes that re-ducing confusion and increasing public access to relevant informa-tion regarding a tax-exempt organization would be achieved by re-quiring a tax-exempt organization to report on its annual return any name under which such organization operates or does busi-ness, and the Internet web site address (if any) of such organiza-tion.63


The provision requires a tax-exempt organization subject to re-porting requirements under section 6033(a) to include on its annual return any name under which such organization operates or does business, and the Internet web site address (if any) of such organi-zation.


36

64 Sec. 6033(a). 65 The staff of the Joint Committee on Taxation recommended the adoption of this provision.

Joint Committee on Taxation, Study of Present-Law Taxpayer Confidentiality and Disclosure Provisions as Required by Section 3802 of the Internal Revenue Service Restructuring and Re-form Act of 1998, Volume II: Study of Disclosure Provisions Relating to Tax-Exempt Organiza-tions (JCS–1–00), January 28, 2000 at 99.

EFFECTIVE DATE

The provision applies to returns filed after December 31, 2002.

C. MODIFICATION TO REPORTING OF CAPITAL TRANSACTIONS


PRESENT LAW

Private foundations are required to file an annual information re-turn (Form 990–PF).64 Part IV of the Form 990–PF requires that private foundations report detailed information regarding the gain or loss from the sale or other disposition of property, including a description of the property sold, how it was acquired (purchase or donation), the date acquired, the date sold, the gross sales price, the amount of depreciation allowed or allowable, and the cost or other basis plus expenses of the sale. Such information generally is required for the IRS to calculate the tax on the private founda-tion’s net investment income. The Form 990–PF is required to be made available to the public.

REASONS FOR CHANGE

Under present law, private foundations that engage in capital transactions must report detailed information about each trans-action on Form 990–PF, which is filed with the IRS and available to the public. For some foundations, listing these transactions in-volves hundreds of pages. The Committee believes that automatic disclosure of such voluminous information does not necessarily ben-efit the public, and may in fact reduce the level of meaningful dis-closure by obscuring other important information. The Committee believes that meaningful disclosure to the public will be increased if the version of the Form 990–PF that is automatically available to the public summarizes rather than lists the capital transactions that affect the calculation of the organization’s net investment in-come. In order to preserve the public’s access to more specific infor-mation regarding such capital transactions, the Committee believes that the more detailed information provided to the IRS on the Form 990–PF should be made available to those members of the public that explicitly request such information.65


The provision requires that any information regarding capital gains and losses that is required to be furnished by private founda-tions in order to calculate the tax on net investment income be fur-nished also in summary form.

In addition, information regarding capital gains and losses re-quired to be filed with the IRS but that is not in summary form is not required to be made available to the public by the IRS or by the private foundation except by the explicit request of a mem-ber of the public to the IRS or to the foundation. A member of the


37

66 The staff of the Joint Committee on Taxation recommended the adoption of this provision. Joint Committee on Taxation, Study of Present-Law Taxpayer Confidentiality and Disclosure Provisions as Required by Section 3802 of the Internal Revenue Service Restructuring and Re-form Act of 1998, Volume II: Study of Disclosure Provisions Relating to Tax-Exempt Organiza-tions (JCS–1–00), January 28, 2000 at 96–97.

public may request disclosure of such information from the Sec-retary, who shall prescribe the manner of making such request and the manner of disclosure. A member of the public also may request disclosure of the private foundation, which must be made in person or in writing. If the request is made in person, the foundation shall provide a copy of the information immediately and, if the request is made in writing, the foundation shall provide the information within 30 days.

The bill also provides that private foundations are required to state on the furnished summary that the more detailed description is available upon request.

EFFECTIVE DATE

The provision applies to returns filed after December 31, 2002.

D. DISCLOSURE THAT FORM 990 IS PUBLICLY AVAILABLE

(Sec. 204 of the bill)

PRESENT LAW

Under present law, there is no requirement that the IRS notify the public that the Form 990 is publicly available.

REASONS FOR CHANGE

The information provided on Forms 990 is useful to the public only to the extent that the public is aware that the form are pub-licly available. The Committee believes that the availability of Forms 990 that have been filed by exempt organizations will be in-creased by requiring the IRS to inform the public regarding the availability of such forms.


The provision requires the IRS to notify the public in appropriate publications and other materials of the extent to which an exempt organization’s Form 990, Form 990–EZ, and Form 990–PF are pub-licly available.66

EFFECTIVE DATE

The provision applies to publications or materials issued or re-vised after the date of enactment.

E. DISCLOSURE TO STATE OFFICIALS OF PROPOSED ACTIONS RELATED TO SECTION 501(C) ORGANIZATIONS


PRESENT LAW

In the case of organizations that are described in section 501(c)(3) and exempt from tax under section 501(a) or that have applied for exemption as an organization so described, present law


38

67 The applicable taxes include the termination tax on private foundations; taxes on public charities for certain excess lobbying expenses; taxes on a private foundation’s net investment income, self-dealing activities, undistributed income, excess business holdings, investments that jeopardize charitable purposes, and taxable expenditures (some of these taxes also apply to cer-tain non-exempt trusts); taxes on the political expenditures and excess benefit transactions of section 501(c)(3) organizations; and certain taxes on black lung benefit trusts and foreign organi-zations.

68 Sec. 6103(a). 69 Sec. 6103(p)(3). 70 Sec. 6103(p)(4). 71 Secs. 7213 and 7213A. 72 Sec. 7431.

(sec. 6104(c)) requires that Secretary to notify the appropriate State officer of (1) a refusal to recognize such organization as an organization described in section 501(c)(3, (2) a revocation of a sec-tion 501(c)(3) organization’s tax-exempt status, and (3) the mailing of a notice of deficiency for an tax imposed under section 507, chap-ter 41, or chapter 42.67 In addition, at the request of such appro-priate State officer, the Secretary is required to make available for inspection and copying, such returns, filed statements, records, re-ports, and other information relating to the above-described disclo-sures, as are relevant to any State law determination. An appro-priate State officer is the State attorney general, State tax officer, or any State official charged with overseeing organizations of the type described in section 501(c)(3).

In general, return and return information (as such terms are de-fined in sec. 6103(b)) is confidential and may not be disclosed or in-spected unless expressly provided by law.68 Present law requires the Secretary to keep records of disclosures and requests for inspec-tion 69 and requires that persons authorized to receive return and return information maintain various safeguards to protect such in-formation against unauthorized disclosure.70 Willful unauthorized disclosure or inspection of return or return information is subject to a fine and/or imprisonment.71 The knowing or negligent unau-thorized inspection or disclosure of returns or return information gives the taxpayer a right to bring a civil suit.72 Such present-law protections against unauthorized disclosure or inspection of return and return information do not apply to the disclosures or inspec-tions, described above, that are authorized by section 6104(c).

REASONS FOR CHANGE

The Committee believes that State officials that are charged with oversight of certain organizations described in section 501(c) have an important and legitimate interest in receiving certain informa-tion about such organizations’ tax-exempt status and tax filings, in some cases before the IRS has made a final determination with re-spect to an organization’s tax-exempt status or liability for tax. By providing appropriate State officials with earlier access to informa-tion about the activities of certain section 501(c) organizations, State officials will be able to monitor such organizations more effec-tively and better protect the public’s interest in assuring that orga-nizations that have been given the benefit of tax-exemption operate consistently with their exempt purposes. In addition, the Com-mittee believes that permitting the IRS to share return and return information about certain section 501(c) organizations with appro-priate State officials, when doing so will facilitate the resolution of


39

73 Such information also may be open to inspection by an appropriate State officer.

Federal or State issues relating to the organization’s tax-exempt status, will significantly improve oversight of such organizations.

The Committee stresses the importance of maintaining the con-fidentiality of taxpayer return and return information and believes it is important to extend existing protections against unauthorized disclosure or inspection of return and return information to disclo-sures made or inspections allowed by the Secretary of return and return information regarding such section 501(c) organizations.


The bill provides that upon written request by an appropriate State officer, the Secretary may disclose: (1) a notice of proposed refusal to recognize an organization as a section 501(c)(3) organiza-tion; (2) a notice of proposed revocation of tax-exemption of a sec-tion 501(c)(3) organization; (3) the issuance of a proposed deficiency of tax imposed under section 507, chapter 41, or chapter 42; (4) the names and taxpayer identification numbers of organizations that have applied for recognition as section 501(c)(3) organizations; and (5) return and return information of organizations 73 with respect to which information has been disclosed under (1) through (4) above. Disclosure or inspection is permitted for the purpose of, and only to the extent necessary in, the administration of State laws regulating section 501(c)(3) organizations, such as laws regulating tax-exempt status, charitable trusts, charitable solicitation, and fraud. Disclosure or inspection may be made only to or by des-ignated representatives of the appropriate State officer, which does not include independent contractors. The Secretary also is per-mitted to disclose or open to inspection the return and return infor-mation of an organization that is recognized as tax- exempt under section 501(c)(3), or that has applied for such recognition, to an ap-propriate State officer if the Secretary determines that disclosure or inspection may facilitate the resolution of Federal or State issues relating to the tax-exempt status of the organization. For this purpose, appropriate State officer means the State attorney general or any other State official charged with overseeing organi-zations of the type described in section 501(c)(3).

In addition, the bill provides that upon the written request by an appropriate State officer, the Secretary may make available for in-spection or disclosure returns and return information of an organi-zation described in section 501(c)(2) (certain title holding compa-nies), 501(c)(4) (certain social welfare organizations), 501(c)(6) (cer-tain business leagues and similar organizations), 501(c)(7) (certain recreational clubs), 501(c)(8) (certain fraternal organizations), 501(c)(10) (certain domestic fraternal organizations operating under the lodge system), and 501(c)(13) (certain cemetery companies). Such return and return information is available for inspection or disclosure only for the purpose of, and to the extent necessary in, the administration of State laws regulating the tax-exempt status of such organizations. Disclosure or inspection may be made only to or by designated representatives of the appropriate State officer, which does not include independent contractors. For this purpose, appropriate State officer means the State attorney general and the head of an agency designated by the State attorney general as hav-


40

74 Treas. Reg. sec. 1.664–1(d)(2).

ing primary responsibility for overseeing the tax-exempt status of such organizations.

In addition, the bill provides that any return and return informa-tion disclosed under section 6104(c) may be disclosed in civil ad-ministrative and judicial proceedings pertaining to the enforcement of State laws regulating the applicable tax-exempt organization in a manner prescribed by the Secretary. Returns and return informa-tion are not to be disclosed under section 6104(c), or in such an ad-ministrative or judicial proceeding, to the extent that the Secretary determines that such disclosure would seriously impair Federal tax administration. The provision makes disclosures of returns and re-turn information under section 6104(c) subject to many of the pro-visions of section 6103, including the requirements that such infor-mation remain confidential (sec. 6103(a)(2)), that the Secretary maintain a permanent system of records of requests for disclosure (sec. 6103(p)(3)), and that the appropriate State officer maintain various safeguards that protect against unauthorized disclosure (sec. 6103(p)(4)). The bill provides that the willful unauthorized dis-closure of return or return information described in section 6104(c) is a felony subject to a fine of up to $5,000 and/or imprisonment of up to five years (sec. 7213(a)(2)), the willful unauthorized inspec-tion of return or return information described in section 6104(c) is subject to a fine of up to $1,000 and/or imprisonment of up to one year (sec. 7213A), and provides the taxpayer the right to bring a civil action for damages in the case of knowing or negligent unau-thorized disclosure or inspection of such information (sec. 7431(a)(2)).

EFFECTIVE DATE

The provision is effective on the date of enactment but does not apply to requests made before such date.

Title III. Other Charitable and Exempt Organization Provisions

A. MODIFY TAX ON UNRELATED BUSINESS TAXABLE INCOME OF CHARITABLE REMAINDER TRUSTS


PRESENT LAW

Charitable remainder annuity trusts and charitable remainder unitrusts are exempt from Federal income tax for a tax year unless the trust has any unrelated business taxable income for the year. Unrelated business taxable income includes certain debt financed income. A charitable remainder trust that loses exemption from in-come tax for a taxable year is taxed as a regular complex trust. As such, the trust is allowed a deduction in computing taxable income for amounts required to be distributed in a taxable year, not to ex-ceed the amount of the trust’s distributable net income for the year. Taxes imposed on the trust are required to be allocated to corpus.74

Distributions from a charitable remainder annuity trust or chari-table remainder unitrust are treated in the following order as: (1) ordinary income to the extent of the trust’s current and previously


41

75 Sec. 664(b). 76 Treas. Reg. sec. 1.664–1(d)(4). 77 Sec. 664(d).

undistributed ordinary income for the trust’s year in which the dis-tribution occurred, (2) capital gains to the extent of the trust’s cur-rent capital gain and previously undistributed capital gain for the trust’s year in which the distribution occurred, (3) other income (e.g., tax-exempt income) to the extent of the trust’s current and previously undistributed other income for the trust’s year in which the distribution occurred, and (4) corpus.75

In general, distributions to the extent they are characterized as income are includible in the income of the beneficiary for the year that the annuity or unitrust amount is required to be distributed even though the annuity or unitrust amount is not distributed until after the close of the trust’s taxable year.76

A charitable remainder annuity trust is a trust that is required to pay, at least annually, a fixed dollar amount of at least five per-cent of the initial value of the trust to a noncharity for the life of an individual or for a period of 20 years or less, with the remainder passing to charity. A charitable remainder unitrust is a trust that generally is required to pay, at least annually, a fixed percentage of at least five percent of the fair market value of the trust’s assets determined at least annually to a noncharity for the life of an indi-vidual or for a period 20 years or less, with the remainder passing to charity.77

A trust does not qualify as a charitable remainder annuity trust if the annuity for a year is greater than 50 percent of the initial fair market value of the trust’s assets. A trust does not qualify as a charitable remainder unitrust if the percentage of assets that are required to be distributed at least annually is greater than 50 per-cent. A trust does not qualify as a charitable remainder annuity trust or a charitable remainder unitrust unless the value of the re-mainder interest in the trust is at least 10 percent of the value of the assets contributed to the trust.

REASONS FOR CHANGE

The Committee believes that in years that a charitable remain-der trust has unrelated business income, an excise tax of 100 per-cent on such income is a more appropriate remedy than loss of tax exemption for the year.


The provision imposes a 100–percent excise tax on the unrelated business taxable income of a charitable remainder trust. This re-places the present-law rule that takes away the income tax exemp-tion of a charitable remainder trust for any year in which the trust has any unrelated business taxable income. Consistent with present law, the tax is treated as paid from corpus. The unrelated business taxable income is considered income of the trust for pur-poses of determining the character of the distribution made to the beneficiary.


42

EFFECTIVE DATE


B. MODIFY TAX TREATMENT OF CERTAIN PAYMENTS TO CONTROLLING EXEMPT ORGANIZATIONS


PRESENT LAW

In general, interest, rents, royalties, and annuities are excluded from the unrelated business income of tax-exempt organizations. However, section 512(b)(13) generally treats otherwise excluded rent, royalty, annuity, and interest income as unrelated business income if such income is received from a taxable or tax-exempt sub-sidiary that is 50 percent controlled by the parent tax-exempt orga-nization. In the case of a stock subsidiary, ‘‘control’’ means owner-ship by vote or value of more than 50 percent of the stock. In the case of a partnership or other entity, control means ownership of more than 50 percent of the profits, capital or beneficial interests. In addition, present law applies the constructive ownership rules of section 318 for purposes of section 512(b)(13). Thus, a parent ex-empt organization is deemed to control any subsidiary in which it holds more than 50 percent of the voting power or value, directly (as in the case of a first-tier subsidiary) or indirectly (as in the case of a second-tier subsidiary).

Under present law, interest, rent, annuity, or royalty payments made by a controlled entity to a tax-exempt organization are in-cludable in the latter organization’s unrelated business income and are subject to the unrelated business income tax to the extent the payment reduces the net unrelated income (or increases any net unrelated loss) of the controlled entity.

The Taxpayer Relief Act of 1997 (the ‘‘1997 Act’’) made several modifications to the control requirement of section 512(b)(13). In order to provide transitional relief, the changes made by the 1997 Act do not apply to any payment received or accrued during the first two taxable years beginning on or after the date of enactment of the 1997 Act (August 5, 1997) if such payment is received or ac-crued pursuant to a binding written contract in effect on June 8, 1997, and at all times thereafter before such payment (but not pur-suant to any contract provision that permits optional accelerated payments).

REASONS FOR CHANGE

The present-law rule that requires a controlling entity to include as unrelated business income certain payments made by a con-trolled entity applies without regard to whether the amount of the payment is fair and reasonable under the circumstances or would otherwise constitute unrelated business income if paid by an orga-nization not controlled by the exempt organization. The Committee believes that the controlling organization should not be subject to the unrelated business income tax if the amount of the payment from the controlled entity is determined in accordance with estab-lished arm’s-length principles. The Committee intends that the con-trolling organization be subject to the present-law rule only to the


43

78 Sec. 501(c)(3).

extent that a payment made by a controlled entity exceeds the amount that would have been paid if the payment had been deter-mined under established arm’s-length principles. In order to dis-courage controlled entities from claiming deductions in excess of the arm’s-length amount, the Committee believes that it is appro-priate to subject the controlling organization to a penalty tax for making excess payments.


The bill provides that the general rule of section 512(b)(13), which includes interest, rent, annuity, or royalty payments made by a controlled entity to a tax-exempt organization in the latter or-ganization’s unrelated business income to the extent the payment reduces the net unrelated income (or increases any net unrelated loss) of the controlled entity, applies only to the portion of pay-ments received or accrued in a taxable year that exceed the amount of the specified payment that would have been paid or accrued if such payment had been determined under the principles of section 482. Thus, if a payment of rent by a controlled subsidiary to its tax-exempt parent organization exceeds fair market value, the ex-cess amount of such payment over fair market value (as deter-mined in accordance with section 482) is included in the parent or-ganization’s unrelated business income, to the extent that such ex-cess reduced the net unrelated income (or increased any net unre-lated loss) of the controlled entity. In addition, the provision im-poses a 20–percent penalty on the larger of such excess determined without regard to any amendment or supplement to a return of tax, or such excess determined with regard to all such amendments and supplements.

The bill provides that if modifications to section 512(b)(13) made by the 1997 Act did not apply to a contract because of the transi-tional relief provided by the 1997 Act, then such modifications also do not apply to amounts received or accrued under such contract before January 1, 2001.

EFFECTIVE DATE

The provision applies to payments received or accrued after De-cember 31, 2000.

C. SIMPLIFICATION OF LOBBYING EXPENDITURE LIMITATION


PRESENT LAW

In general An organization does not qualify for tax-exempt status under sec-

tion 501(c)(3) unless ‘‘no substantial part’’ of the activities of the or-ganization is ‘‘carrying on propaganda, or otherwise attempting, to influence legislation,’’ except as provided by section 501(h).78 Car-rying on propaganda and attempting to influence legislation com-monly are referred to as ‘‘lobbying’’ activities. Thus, section


44

79 Organizations that do not make a section 501(h) election are subject to the ‘‘no substantial part’’ test.

80 Secs. 501(h)(2)(A), 4911(c)(1), 4911(d). 81 Exempt purpose expenditures generaally are expenses incurred for exempt purposes, such

as amounts paid to accomplish exempt purposes, administrative expenses such as overhead, lob-bying expenses, and certain fundraising expenses. Exempt purpose expenditures do not include, for example, expenses not for exempt purposes, payments of unrelated business income tax, or capital expenses in connection with an unrelated business. See Treas. Reg. sec. 56.4911–4.

82 Sec. 501(h)(1). 83 Treas. Reg. sec. 1.501(h)–3. 84 Secs. 501(h)(2)(C) & 4911(d)(1)(A).

501(c)(3) permits a limited amount of lobbying activity without loss of tax-exempt status.

For purposes of determining whether lobbying activities are a substantial part of an organization’s overall functions, an organiza-tion may choose between two standards, the ‘‘no substantial part’’ test of section 501(c)(3) or the ‘‘expenditure’’ test of section 501(h).

Whether an organization meets the ‘‘no substantial part’’ test is based on all the facts and circumstances. There is no statutory or regulatory guidance, and it is not clear whether the determination is based on the organization’s activities, its expenditures, or both. Alternatively, under section 501(h), certain organizations described in section 501(c)(3) can elect to be subject to the expenditure test,79 which consists of bright-line rules that specify the dollar amount of permitted expenses on lobbying activities.

Consequences of excess lobbying under section 501(h) Organizations that make a section 501(h) election (‘‘electing char-

ities’’) are subject to tax if the electing charity makes either ‘‘lob-bying expenditures’’ or ‘‘grass roots expenditures’’ in excess of a cer-tain amount established for each type of expenditure for each tax-able year. Lobbying expenditures are the sum of grass-roots ex-penditures and ‘‘direct lobbying’’ expenditures.80

The expenditure limits are based on a ‘‘lobbying nontaxable amount’’ for the taxable year and a ‘‘grass roots nontaxable amount’’ for the taxable year. The lobbying nontaxable amount is the lesser of $1 million or an amount determined as a percentage of an organization’s exempt purpose expenditures.81 The grass-roots nontaxable amount is 25 percent of the organization’s lob-bying nontaxable amount. An electing charity that exceeds either of the spending limitations is subject to a 25 percent tax on the ex-cess. An electing charity that exceeds both of the spending limita-tions is subject to a 25 percent tax on the greater of the excess of the lobbying expenditures or the grass-roots expenditures.

An electing charity that normally exceeds either of two ‘‘ceiling amounts,’’ which are based on the expenditure limits, will lose its tax exemption.82 The ‘‘lobbying ceiling amount’’ is 150 percent of the electing charity’s lobbying nontaxable amount for the taxable year and the ‘‘grass roots ceiling amount’’ is 150 percent of the grass-roots nontaxable amount for the taxable year. For this pur-pose, ‘‘normal’’ expenditures are calculated based on a four-year averaging mechanism.83

Definitions Grass-roots expenditures are defined as ‘‘any attempt to influ-

ence any legislation through an attempt to affect the opinions of the general public or any segment thereof.’’ 84 For a communication


45

85 Treas. Reg. sec. 56.4911–2(b)(2)(i). 86 Treas. Reg. sec. 56.4911–2(b)(2)(iii). The regulations provide that the first three elements

constitute ‘‘direct’’ encouragement, whereas the fourth element is ‘‘indirect’’ encouragement. This distinction becomes relevant in determining whether a communication meets one of the pre-scribed exceptions to lobbying, i.e., an indirect call to action in a grass-roots communication may qualify as ‘‘nonpartisan analysis, study or research’’ (Treas. Reg. sec. 56.4911–2(b)(2)(iv)), and in determining the proper allocation of expenses between grass-roots and direct lobbying. Treas. Reg. sec. 56.4911–5(e).

87 Treas. Reg. sec. 56.4911–2(b)(5)(ii). 88 Id.89 Secs. 501(h)(2)(A) and 4911(d)(1)(B) and Treas. Reg. sec. 56.4911–2(b)(1).

to constitute grass-roots lobbying, it must refer to ‘‘specific legisla-tion,’’ reflect a view on such legislation, and encourage the recipient of the communication to take action with respect to such legislation (a ‘‘call to action’’).85 A communication includes a call to action if it incorporates one of four elements: (1) it urges the recipient to contact a legislator, employee of a government body, or any other government official or employee who may participate in the formu-lation of legislation with the principal purpose of influencing legis-lation; (2) it states the address, telephone number, or similar infor-mation of a legislator or an employee of a legislative body; (3) it provides a petition, tear-off postcard, or similar device for the re-cipient to communicate with government officials or employees who participate in the formulation of legislation with the principal pur-pose of influencing legislation; or (4) it states the position of one or more legislators on the legislation, except that a communication may name the main sponsors of legislation for purposes of identi-fying the legislation without constituting a call to action.86 In addi-tion, a communication is presumed to be grass-roots lobbying if the communication is a paid advertisement that: (1) appears in the mass media within two weeks before a vote by a legislative body or committee (but not a subcommittee) on a highly publicized piece of legislation; (2) reflects a view on the general subject of the legis-lation; and (3) either refers to the legislation or encourages the public to communicate with legislators on the general subject of such legislation.87 The presumption is rebuttable if the electing charity demonstrates that the timing of the communication was not related to the legislation or that the advertisement was of a type regularly made by the electing charity without regard to the timing of the legislation (a customary course of business exception).88

Direct lobbying expenditures are ‘‘any attempt to influence any legislation through communication with any member or employee of a legislative body, or with any government official or employee who may participate in the formulation of the legislation’’ if the principal purpose of the communication is to influence legislation.89 A communication would constitute direct lobbying only if the com-munication ‘‘refers to specific legislation’’ and reflects a view on such legislation.

Certain specified activities do not constitute attempts to influ-ence legislation and therefore expenditures for such activities are not subject to the expenditure limits for lobbying expenditures or grass-roots expenditures. In general, such activities include: (1) making available the results of nonpartisan analysis, study, or re-search; (2) providing technical advice or assistance to a govern-mental body or to a committee in response to a written request; (3) appearances before, or communications to, any legislative body with respect to a possible decision of such body that might affect


reasons for change 46

90 Sec. 4911(d)(2). 91 Treas. Reg. sec. 56.4911–59(e). 92 See Treas. Reg. sec. 56.4911–6.

the existence of the organization, its powers and duties, tax-exempt status, or the deduction of contributions to the organization (so-called ‘‘self-defense’’ expenditures); (4) certain communications to members of the electing charity; and (5) communications with gov-ernmental officials or employees that are not intended to influence legislation.90

Special rules for mixed lobbying expenditures Expenses that serve both direct and grass-roots lobbying pur-

poses, e.g., communications that are sent to members and nonmem-bers, or ‘‘mixed lobbying’’ expenditures, are subject to special rules. The regulations specify how an electing charity is to allocate mixed lobbying expenditures between direct and grass-roots lobbying pur-poses.91 For example, for a mixed lobbying communication that is designed primarily for members (i.e., more than half the recipients are members) and that directly encourages grass-roots lobbying (even if it also encourages direct lobbying), the grass-roots expendi-ture amount includes all the costs of preparing the material used for purposes of grass-roots lobbying plus the mechanical and dis-tributional costs associated with the communication. If a mixed lob-bying communication encourages direct lobbying, but only indi-rectly encourages grass-roots lobbying, then the entire costs of the communication are allocated based on the proportion of members and nonmembers receiving the communication.

Disclosure of lobbying expenditures An electing charity must disclose lobbying expenditures annually

on Schedule A of Form 990. In order to meet disclosure require-ments, electing charities are required to keep detailed records of di-rect and grass-roots lobbying expenditures. Required records of grass-roots expenditures include: (1) all amounts directly paid or incurred for grass-roots lobbying; (2) payments to other organiza-tions earmarked for grass-roots lobbying; (3) fees and expenses paid for grass-roots lobbying; (4) the printing, mailing, and other costs of reproducing and distributing materials used in grass-roots lob-bying; (5) the portion of amounts paid or incurred as current or de-ferred compensation for an employee’s grass-roots lobbying serv-ices; (6) any amount paid for out-of-pocket expenditures incurred on behalf of the electing charity for grass-roots lobbying; (7) the al-locable portion of administrative, overhead and other general ex-penditures attributable to grass-roots lobbying; and (8) expendi-tures for grass-roots lobbying of a controlled organization.92

REASONS FOR CHANGE

The Committee believes that the separate limitation on grass-roots lobbying expenditures is an unnecessary complication for electing charities. The Committee believes that the overall limit on lobbying expenditures is a sufficient ceiling on the lobbying activi-ties of electing charities, irrespective of the proportion of lobbying activities that are grass-roots lobbying or direct lobbying.


47

93 Sec. 508(a).


The provision eliminates the separate limitation for grass-roots lobbying expenditures applicable to electing charities. Electing charities remain subject to the overall limitation on lobbying ex-penditures, which does not change in amount, but electing charities are not required to limit grass roots expenditures as a percentage of overall lobbying. Thus, an electing charity is able to make tax-free any combination of grass-roots and direct lobbying expendi-tures up to the lobbying non-taxable amount and does not risk loss of tax-exemption as a result of such expenditures until total lob-bying expenditures normally exceed the lobbying ceiling amount. For purposes of the section 501(h) election, electing charities are not required to distinguish between grass-roots lobbying and direct lobbying, whether for mixed lobbying expenditures or otherwise.

EFFECTIVE DATE


D. EXPEDITED REVIEW PROCESS FOR CERTAIN TAX-EXEMPTION APPLICATIONS


PRESENT LAW

Most organizations that seek tax-exempt status as a charitable organization are required to file an Application for Recognition of Exemption (Form 1023) with the IRS.93 Organizations that are not required to file Form 1023 include churches, their integrated auxil-iaries, and conventions or associations of churches, and any organi-zation (other than a private foundation) that normally has gross re-ceipts of $5,000 or less in a taxable year. Organizations that file Form 1023 within 15 months of the end of the month of the organi-zation’s formation will, if the application is approved, be recognized as tax-exempt from the date of formation. The IRS will automati-cally grant an organization’s request for an additional 12–month extension of the 15-month period. Otherwise, exemption normally will be recognized as of the date the application was received by the IRS. In appropriate circumstances, upon written request, the IRS will expedite consideration of applications for tax-exemption. For example, organizations formed to provide relief to victims of disasters or other emergencies often receive expedited consider-ation.

REASONS FOR CHANGE

Many social service organizations that want to apply for govern-ment funding through grants or contracts are required as a condi-tion of application to have been recognized as an exempt charitable organization. The Committee wishes to facilitate the formation of charitable organizations that intend to work with Federal, State and local governments to provide vital social services to many of the neediest members of society by implementing an expedited re-view procedure for exempt status applications, and by waiving IRS



user fees pertaining to such applications filed by smaller social service organizations.


The bill provides that the Secretary or its delegate shall adopt procedures to expedite consideration of applications for exempt sta-tus by organizations that are organized and operated for the pri-mary purpose of providing social services. To be eligible, the orga-nization must: (1) be seeking a contract or grant under a Federal, State, or local program that provides funding for social service pro-grams; (2) establish that tax-exempt status is a condition of apply-ing for such contract or grant; (3) include a completed copy of the contract or grant application with the application for exemption; and (4) meet such other criteria as the Secretary may provide. Or-ganizations that meet the eligibility requirements described above (except for the requirement that tax-exempt status is a condition of the contract or grant application), and that certify that the orga-nization’s average annual gross receipts over the four year period preceding the application was not more than $50,000 (or, in the case of an organization in existence less than four years, is not ex-pected to be more than $50,000 during the organization’s first four years) are entitled to a waiver of any fee for application of tax-ex-empt status.

For this purpose, social services is defined as services directed at helping people in need, reducing poverty, improving outcomes of low-income children, revitalizing low-income communities, and em-powering low-income families and low-income individuals to be-come self-sufficient, including: (1) child care services, protective services for children and adults, services for children and adults in foster care, adoption services, services related to the management and maintenance of the home, day care services for adults, and services to meet the special needs of children, older individuals, and individuals with disabilities (including physical, mental, or emotional disabilities); (2) transportation services; (3) job training and related services, and employment services; (4) information, re-ferral, and counseling services; (5) the preparation and delivery of meals, and services related to soup kitchens or food banks; (6) health support services; (7) literacy and mentoring programs; (8) services for the prevention and treatment of juvenile delinquency and substance abuse, services for the prevention of crime and the provision of assistance to the victims and the families of criminal offenders, and services related to the intervention in, and preven-tion of, domestic violence; and (9) services related to the provision of assistance for housing under Federal law. Social services does not include a program having the purpose of delivering educational assistance under the Elementary and Secondary Education Act of 1965 or under the Higher Education Act of 1965.

EFFECTIVE DATE

The provision applies to applications for tax-exempt status filed after December 31, 2002.


49

94 Sec. 7611. Prior to the year 2000 IRS restructuring, the lowest level official who could ini-tiate a church tax inquiry was an IRS Regional Commissioner.

E. CLARIFICATION OF DEFINITION OF CHURCH TAX INQUIRY


PRESENT LAW

Under present law, the IRS may begin a church tax inquiry only if an appropriate high-level Treasury official reasonably believes, on the basis of the facts and circumstances recorded in writing, that an organization (1) may not qualify for tax exemption as a church, (2) may be carrying on an unrelated trade or business, or (3) otherwise may be engaged in taxable activities.94 A church tax inquiry is defined as any inquiry to a church (other than an exam-ination) that serves as a basis for determining whether the organi-zation qualified for tax exemption as a church or whether it is car-rying on an unrelated trade or business or otherwise is engaged in taxable activities. An inquiry is considered to commence when the IRS requests information or materials from a church of a type con-tained in church records, other than routine requests for informa-tion or inquiries regarding matters that do not primarily concern the tax status or liability of the church itself.

REASONS FOR CHANGE

The Committee believes that the present-law church tax inquiry procedures provide important safeguards against the IRS engaging in unnecessary and intrusive examinations of churches. However, the church tax inquiry procedures also have the effect of hampering IRS efforts to educate churches with respect to actions that are not permissible under section 501(c)(3). The Committee believes that a clarification of the scope of the church tax inquiry procedures to make it clear that the IRS may undertake educational outreach ef-forts with respect to specific churches (e.g., initiating meetings with representatives of a particular church to discuss the rules that apply to such church) will improve compliance with the law by churches.


The provision clarifies that the church tax inquiry procedures do not apply to contacts made by the IRS for the purpose of educating churches with respect to the federal income tax law governing tax-exempt organizations. For example, the IRS does not violate the church tax inquiry procedures when written materials are provided to a church or churches for the purpose of educating such church or churches with respect to the types of activities that are not per-missible under section 501(c)(3).

EFFECTIVE DATE

The provision is effective on the date of enactment.



F. EXTENSION OF DECLARATORY JUDGMENT PROCEDURES TO NON-501(C)(3) TAX-EXEMPT ORGANIZATIONS (SEC. 306 OF THE BILL AND SEC. 7428 OF THE CODE)

PRESENT LAW

In order for an organization to be granted tax exemption as a charitable entity described in section 501(c)(3), it generally must file an application for recognition of exemption with the IRS and receive a favorable determination of its status. Similarly, for most organizations, a charitable organization’s eligibility to receive tax-deductible contributions is dependent upon its receipt of a favor-able determination from the IRS. In general, a section 501(c)(3) or-ganization can rely on a determination letter or ruling from the IRS regarding its tax-exempt status, unless there is a material change in its character, purposes, or methods of operation. In cases in which an organization violates one or more of the requirements for tax exemption under section 501(c)(3), the IRS is authorized to revoke an organization’s tax exemption, notwithstanding an earlier favorable determination.

In situations in which the IRS denies an organization’s applica-tion for recognition of exemption under section 501(c)(3) or fails to act on such application, or in which the IRS informs a section 501(c)(3) organization that it is considering revoking or adversely modifying its tax-exempt status, present law authorizes the organi-zation to seek a declaratory judgment regarding its tax status (sec. 7428). Section 7428 provides a remedy in the case of a dispute in-volving a determination by the IRS with respect to: (1) the initial qualification or continuing qualification of an organization as a charitable organization for tax exemption purposes or for charitable contribution deduction purposes; (2) the initial classification or con-tinuing classification of an organization as a private foundation; (3) the initial classification or continuing classification of an organiza-tion as a private operating foundation; or (4) the failure of the IRS to make a determination with respect to (1), (2), or (3). A ‘‘deter-mination’’ in this context generally means a final decision by the IRS affecting the tax qualification of a charitable organization, al-though it also can include a proposed revocation of an organiza-tion’s tax-exempt status or public charity classification. Section 7428 vests jurisdiction over controversies involving such a deter-mination in the U.S. District Court for the District of Columbia, the U.S. Court of Federal Claims, and the U.S. Tax Court.

Prior to utilizing the declaratory judgment procedure, an organi-zation must have exhausted all administrative remedies available to it within the IRS. An organization is deemed to have exhausted its administrative remedies at the expiration of 270 days after the date on which the request for a determination was made if the or-ganization has taken, in a timely manner, all reasonable steps to secure such determination.

If an organization (other than a section 501(c)(3) organization) files an application for recognition of exemption and receives a fa-vorable determination from the IRS, the determination of tax-ex-empt status is usually effective as of the date of formation of the organization if its purposes and activities during the period prior to the date of the determination letter were consistent with the re-quirements for exemption. However, if the organization files an ap-


51

95 This limitation currently applies to declaratory judgments relating to tax qualification for certain employee retirement plans (sec. 7476).

96 Sec. 6033(a)(2)(A)(i). 97 Sec. 7611(h)(1)(B). 98 See, e.g., Sec. 402(g)(8)(B) (limitation on elective deferrals); sec. 403(b)(9)(B) (definition of

retirement income account); sec. 410(d) (election to have participation, vesting, funding, and cer-tain other provisions apply to church plans); sec. 414(e) (definition of church plan); sec. 415(c)(7) (certain contributions by church plans); sec. 501(h)(5) (disqualification of certain organizations from making the sec. 501(h) election regarding lobbying expenditure limits); sec. 501(m)(3) (defi-nition of commercial-type insurance); sec. 508(c)(1)(A) (exception from requirement to file appli-

Continued

plication for recognition of exemption and later receives an adverse determination from the IRS, the IRS may assert that the organiza-tion is subject to tax on some or all of its income for open taxableyears. In addition, as with charitable organizations, the IRS may revoke or modify an earlier favorable determination regarding an organization’s tax-exempt status.

Under present law, a non-charity (i.e., an organization not de-scribed in section 501(c)(3)) may not seek a declaratory judgment with respect to an IRS determination regarding its tax-exempt sta-tus. The only remedies available to such an organization are to pe-tition the U.S. Tax Court for relief following the issuance of a no-tice of deficiency or to pay any tax owed and sue for refund in fed-eral district court or the U.S. Court of Federal Claims.

REASONS FOR CHANGE

The Committee believes that it is important to provide certainty for organizations that have sought a determination of their tax-ex-empt status. Thus, the Committee finds it appropriate to extend the present-law declaratory judgment procedures to all organiza-tions that apply for tax-exempt status as organizations described in section 501(c).


The provision extends declaratory judgment procedures similar to those currently available only to charities under section 7428 to other section 501(c) determinations. The provision limits jurisdic-tion over controversies involving such determinations to the United States Tax Court.95

EFFECTIVE DATE

The extension of the declaratory judgment procedures to organi-zations other than section 501(c)(3) organizations is effective for pleadings filed with respect to determinations made after Decem-ber 31, 2001.

G. DEFINITION OF CONVENTION OR ASSOCIATION OF CHURCHES


PRESENT LAW

Under present law, an organization that qualifies as a ‘‘conven-tion or association of churches’’ (within the meaning of sec. 170(b)(1)(A)(i)) is not required to file an annual return,96 is subject to the church tax inquiry and church tax examination provisions applicable to organizations claiming to be a church,97 and is subject to certain other provisions generally applicable to churches.98 The



cation seeking recognition of exempt status); sec. 512(b)(12) (allowance of up to $1,000 deduction for purposes of determining unrelated business taxable income); sec. 514(b)(3)(E) (definition of debt-financed property); sec. 3121(w)(3)(A) (election regarding exemption from social security taxes); sec. 3309(b)(1) (application of federal unemployment tax provisions to services performed in the employ of certain organizations); sec. 6043(b)(1) (requirement to file a return upon liq-uidation or dissolution of the organization); and sec. 7702(j)(3)(A) (treatment of certain death benefit plans as life insurance).

Internal Revenue Code does not define the term ‘‘convention or as-sociation of churches.’’

REASONS FOR CHANGE

The term ‘‘convention or association of churches’’ was added to the Code to ensure that hierarchical churches and congregational churches would not be treated dissimilarly for Federal income tax purposes merely because of their organizational and governance structures. The Committee understands that some congregational church organizations have only churches as members, and that oth-ers have both churches and individuals as members. The Com-mittee is concerned that an organization with the characteristics of a convention or association of churches, including having a sub-stantial number of churches as members, might fail to be regarded as a convention or association of churches merely because it in-cludes individuals in its membership. The Committee intends that a congregational church organization that otherwise constitutes a convention or association of churches not be denied recognition as such merely because its membership includes individuals as well as churches.


The bill provides that an organization that otherwise is a conven-tion or association of churches does not fail to so qualify merely be-cause the membership of the organization includes individuals as well as churches, or because individuals have voting rights in the organization.

EFFECTIVE DATE


H. CHARITABLE CONTRIBUTION DEDUCTION FOR CERTAIN EXPENSES IN SUPPORT OF NATIVE ALASKAN SUBSISTENCE WHALING


PRESENT LAW

In computing taxable income, individuals who do not elect the standard deduction may claim itemized deductions, including a de-duction (subject to certain limitations) for charitable contributions or gifts made during the taxable year to a qualified charitable orga-nization or governmental entity (sec. 170). Individuals who elect the standard deduction may not claim a deduction for charitable contributions made during the taxable year.

No charitable contribution deduction is allowed for a contribution of services. However, unreimbursed expenditures made incident to the rendition of services to an organization, contributions to which are deductible, may constitute a deductible contribution (Treas. Reg. sec. 1.170A–1(g)). Specifically, section 170(j) provides that no


53

charitable contribution deduction is allowed for traveling expenses (including amounts expended for meals and lodging) while away from home, whether paid directly or by reimbursement, unless there is no significant element of personal pleasure, recreation, or vacation in such travel.

REASONS FOR CHANGE

The Committee believes that subsistence bowhead whale hunting activities are important to certain native peoples of Alaska and fur-ther charitable purposes. The Committee believes that certain ex-penses paid by individuals recognized as whaling captains by the Alaska Eskimo Whaling Commission in the conduct of sanctioned whaling activities conducted pursuant to the management plan of that Commission should be deductible as charitable contributions even though they are paid other than directly to a charitable orga-nization.


The provision allows certain individuals to claim a deduction under section 170 not exceeding $7,500 per taxable year for certain expenses incurred in carrying out sanctioned whaling activities. The deduction is available only to an individual who is recognized by the Alaska Eskimo Whaling Commission as a whaling captain charged with the responsibility of maintaining and carrying out sanctioned whaling activities. The deduction is available for reason-able and necessary expenses paid by the taxpayer during the tax-able year for: (1) the acquisition and maintenance of whaling boats, weapons, and gear used in sanctioned whaling activities, (2) the supplying of food for the crew and other provisions for carrying out such activities, and (3) storage and distribution of the catch from such activities. The Committee intends that the Secretary shall re-quire that the taxpayer substantiate deductible expenses by main-taining appropriate written records that show, for example, the time, place, date, amount, and nature of the expense, as well as the taxpayer’s eligibility for the deduction. In addition, the Committee believes that it is appropriate for the taxpayer to provide such sub-stantiation as part of the taxpayer’s income tax return, to the ex-tent provided by the Secretary.

For purposes of the provision, the term ‘‘sanctioned whaling ac-tivities’’ means subsistence bowhead whale hunting activities con-ducted pursuant to the management plan of the Alaska Eskimo Whaling Commission.

EFFECTIVE DATE

The provision applies to expenses paid after December 31, 2002, in taxable years ending after such date.

I. PAYMENTS BY CHARITABLE ORGANIZATIONS TO VICTIMS OF WAR ON TERRORISM


PRESENT LAW

In general, organizations described in section 501(c)(3) of the Code are exempt from taxation. Contributions to such organiza-



99 Sec. 170. 100 Sec. 4941.

tions generally are tax deductible.99 Section 501(c)(3) organizations must be organized and operated exclusively for exempt purposes and no part of the net earnings of such organizations may inure to the benefit of any private shareholder or individual. An organi-zation is not organized or operated exclusively for one or more ex-empt purposes unless the organization serves a public rather than a private interest. Thus, an organization described in section 501(c)(3) generally must serve a charitable class of persons that is indefinite or of sufficient size.

Tax-exempt private foundations are a type of organization de-scribed in section 501(c)(3) and are subject to special rules. Private foundations are subject to excise taxes on acts of self-dealing be-tween the private foundation and a disqualified person with respect to the foundation.100 For example, it is self-dealing if assets of a private foundation are used for the benefit of a disqualified person, such as a substantial contributor to the foundation or a person in control of the foundation, and the benefit is not incidental or ten-uous.

REASONS FOR CHANGE

The Committee believes that payments by charities to members of the Armed Forces of the United States (and their immediate families) made by reason of death, injury, wounding or illness and incurred as a result of our nation’s military response to the ter-rorist attacks of September 11, 2001, should be treated as con-sistent with the charity’s exempt purpose, to the extent the pay-ments are made in good faith and pursuant to a reasonable and ob-jective formula that is consistently applied.


The bill provides that organizations described in section 501(c)(3) that make certain payments are not required to make a specific as-sessment of need for the payments to be related to the purpose or function constituting the basis for the organization’s exemption, provided that the organization makes the payments in good faith and uses an objective formula that is consistently applied in mak-ing the payments.

The provision applies to payments to a member of the Armed Forces of the United States (as defined in section 7701(a)(15)), or to a member of such person’s immediate family (including spouses, parents, children, and foster children), by reason of the death, in-jury, wounding, or illness of a member of the Armed Forces of the United States that was incurred as a result of the military re-sponse of the United States to the terrorist attacks against the United States on September 11, 2001. As under present law, such payments must be for public and not private benefit and therefore must serve a charitable class. For example, a charitable organiza-tion that assists the families of members of the Armed Forces killed in the line of duty may make pro-rata distributions to the families of those killed, even though the specific financial needs of each family are not directly considered. Similarly, if the amount of a distribution is based on the number of dependents of a charitable


55

class of persons killed in the military response to the attacks and this standard is applied consistently among distributions, the spe-cific needs of each recipient do not have to be taken into account. However, it is not appropriate for a charity to make pro-rata pay-ments based on the recipients’ living expenses before the harm oc-curred if the result generally provides significantly greater assist-ance to persons in a better position to provide for themselves than to persons with fewer financial resources. Although such a distribu-tion might be based on objective criteria, it is not a reasonable for-mula for distributing assistance in an equitable manner. Similarly, although specific assessments of need are not required, payments that do not further public purposes are not permitted. The provi-sion does not change the substantive standards for exemption under section 501(c)(3), including the prohibition on private inurement. The provision also provides that if a private foundation makes payments under the conditions described above, the pay-ment is not treated as made to a disqualified person for purposes of section 4941.

EFFECTIVE DATE

The provision applies to payments made after the date of enact-ment and before September 11, 2003.

J. MODIFY RULES GOVERNING TAX-EXEMPT BONDS FOR SECTION 501(C)(3) ORGANIZATIONS AS APPLIED TO ORGANIZATIONS EN-GAGED IN TIMBER CONSERVATION ACTIVITIES


PRESENT LAW

Interest on State or local government bonds is tax-exempt when the proceeds of the bonds are used to finance activities carried out by or paid for by those governmental units. Interest on bonds issued by State or local governments acting as conduit borrowers for private businesses is taxable unless a specific exception is in-cluded in the Code. One such exception allows tax-exempt bonds to be issued to finance activities of non-profit organizations described in Code section 501(c)(3) (‘‘qualified 501(c)(3) bonds’’).

Qualified 501(c)(3) bonds may be issued only to finance the ac-tivities that qualify the organization for tax-exemption, as opposed to unrelated business activities of these organizations. If the bonds are issued to finance property that is intended to be sold to a pri-vate business while the bonds are outstanding, bond interest may not qualify for tax-exemption. Similarly, if the property is in fact sold, bond interest may become retroactively taxable unless reme-dial actions specified in Treasury Department regulations are taken. An example of such a situation would be qualified 501(c)(3) bonds issued to finance the purchase of land and standing timber when the timber was to be sold.

As is true of governmental activities receiving tax-exempt financ-ing, section 501(c)(3) organizations are restricted in the arrange-ments they may have with private businesses relating to control and use of bond-financed property.



REASONS FOR CHANGE

The Committee notes that thousands of acres of productive forest are being lost to urban uses. The Committee believes it is appro-priate to offer greater protection of areas of particular environ-mental sensitivity and open space, while at the same time main-taining viable forest operations and jobs near growing urban areas. This provision will give qualified 501(c)(3) organizations the flexi-bility to acquire and preserve larger tracts of forest land by low-ering the financing costs. Thus, the provision should reduce the need to acquire these lands on a smaller, more piecemeal basis. Further, by allowing trees to be harvested to cover the bond pay-ments, the provision will provide jobs, while subjecting the land to a conservation easement will preserve areas of particular environ-mental sensitivity and open space.


The provision modifies the rules governing issuance of qualified 501(c)(3) bonds to permit the issuance of long-term bonds for the acquisition of land and timber associated with such land subject to a conservation restriction. Under the provision, the bonds will not fail to be qualified 501(c)(3) bonds if the timber is sold or leased to, or otherwise used by, an unrelated person to the extent that such sale, leasing, or other use does not constitute an unrelated trade or business, and so long as the other requirements of the pro-vision are met. In addition, these bonds will not be qualified 501(c)(3) bonds unless the seller of the land and timber property that is to be acquired with the bond proceeds irrevocably elects not to exclude from income any portion of the gain on the sale of such property made for qualifying conservation purposes under section 121A of the Code as added by section 107 of the bill.

Under the provision, section 501(c)(3) organizations may enter into certain otherwise prohibited timber management arrange-ments with private businesses without losing tax-exemption on bonds used to finance the property and timber provided that those arrangements do not constitute an unrelated trade or business with respect to the organization. Similarly, the bonds may be issued on a tax-exempt basis notwithstanding plans by the section 501(c)(3) organization to harvest and sell standing timber on land being ac-quired.

The provision imposes a national limitation of $2 billion on the aggregate amount of bonds that may be issued pursuant to this provision. This volume limitation, for the period October 1, 2002, to December 31, 2005, will be allocated by the Department of Treasury to qualified section 501(c)(3) organizations based on cri-teria established by the Department of Treasury (after consultation with appropriate Federal, State, and local officials). The Committee anticipates that the criteria will be based on, among other factors, the environmental merit and economic viability of a particular project, rather than an attempt to achieve geographical balance in making the allocations. The Committee further expects that no later than 90 days after the date of enactment, the Department of Treasury will issue guidance that specifies (1) how section 501(c)(3) organizations are to apply for an allocation and (2) the procedure


57

through which such allocations are to be made to the appropriate organizations.

EFFECTIVE DATE

The provision is effective for bonds issued after September 30, 2002 and before January 1, 2006.

K. PROVIDE TAX EXEMPTION FOR ORGANIZATIONS CREATED BY A STATE TO PROVIDE PROPERTY AND CASUALTY INSURANCE COV-ERAGE FOR PROPERTY FOR WHICH SUCH COVERAGE IS OTHERWISE UNAVAILABLE

(Sec. 311 of the bill and sec. 501(c)(28) of the Code)

PRESENT LAW

In general A life insurance company is subject to tax on its life insurance

company taxable income, which is its life insurance income reduced by life insurance deductions (sec. 801). Similarly, a property and casualty insurance company is subject to tax on its taxable income, which is determined as the sum of its underwriting income and in-vestment income (as well as gains and other income items) (sec. 831). Present law provides that the term ‘‘corporation’’ includes an insurance company (sec. 7701(a)(3)).

In general, the Internal Revenue Service (‘‘IRS’’) takes the posi-tion that organizations that provide insurance for their members or other individuals are not considered to be engaged in a tax-exempt activity. The IRS maintains that such insurance activity is either (1) a regular business of a kind ordinarily carried on for profit, or (2) an economy or convenience in the conduct of members’ busi-nesses because it relieves the members from obtaining insurance on an individual basis.

Certain insurance risk pools have qualified for tax exemption under Code section 501(c)(6). In general, these organizations (1) as-sign any insurance policies and administrative functions to their member organizations (although they may reimburse their mem-bers for amounts paid and expenses); (2) serve an important com-mon business interest of their members; and (3) must be member-ship organizations financed, at least in part, by membership dues.

State insurance risk pools may also qualify for tax-exempt status under section 501(c)(4) as a social welfare organization or under section 115 as serving an essential governmental function of a State. In seeking qualification under section 501(c)(4), insurance organizations generally are constrained by the restrictions on the provision of ‘‘commercial-type insurance’’ contained in section 501(m). Section 115 generally provides that gross income does not include income derived from the exercise of any essential govern-mental function and accruing to a State or any political subdivision thereof.

Certain specific provisions provide tax-exempt status to organiza-tions meeting statutory requirements.

Health coverage for high-risk individuals Section 501(c)(26) provides tax-exempt status to any membership

organization that is established by a State exclusively to provide



coverage for medical care on a nonprofit basis to certain high-risk individuals, provided certain criteria are satisfied. The organization may provide coverage for medical care either by issuing insurance itself or by entering into an arrangement with a health mainte-nance organization (‘‘HMO’’).

High-risk individuals eligible to receive medical care coverage from the organization must be residents of the State who, due to a pre-existing medical condition, are unable to obtain health cov-erage for such condition through insurance or an HMO, or are able to acquire such coverage only at a rate that is substantially higher than the rate charged for such coverage by the organization. The State must determine the composition of membership in the organi-zation. For example, a State could mandate that all organizations that are subject to insurance regulation by the State must be mem-bers of the organization.

The provision further requires the State or members of the orga-nization to fund the liabilities of the organization to the extent that premiums charged to eligible individuals are insufficient to cover such liabilities. Finally, no part of the net earnings of the organiza-tion can inure to the benefit of any private shareholder or indi-vidual.

Workers’ compensation reinsurance organizations Section 501(c)(27)(A) provides tax-exempt status to any member-

ship organization that is established by a State before June 1, 1996, exclusively to reimburse its members for workers’ compensa-tion insurance losses, and that satisfies certain other conditions. A State must require that the membership of the organization consist of all persons who issue insurance covering workers’ compensation losses in such State, and all persons and governmental entities who self-insure against such losses. In addition, the organization must operate as a nonprofit organization by returning surplus income to members or to workers’ compensation policyholders on a periodic basis and by reducing initial premiums in anticipation of invest-ment income.

State workmen’s compensation act companies Section 501(c)(27)(B) provides tax-exempt status for any organi-

zation that is created by State law, and organized and operated ex-clusively to provide workmen’s compensation insurance and related coverage that is incidental to workmen’s compensation insurance, and that meets certain additional requirements. The workmen’s compensation insurance must be required by State law, or be in-surance with respect to which State law provides significant dis-incentives if it is not purchased by an employer (such as loss of ex-clusive remedy or forfeiture of affirmative defenses such as con-tributory negligence). The organization must provide workmen’s compensation to any employer in the State (for employees in the State or temporarily assigned out-of-State) seeking such insurance and meeting other reasonable requirements. The State must either extend its full faith and credit to the initial debt of the organization or provide the initial operating capital of such organization. For this purpose, the initial operating capital can be provided by pro-viding the proceeds of bonds issued by a State authority; the bonds may be repaid through exercise of the State’s taxing authority, for


59

example. For periods after the date of enactment, either the assets of the organization must revert to the State upon dissolution, or State law must not permit the dissolution of the organization ab-sent an act of the State legislature. Should dissolution of the orga-nization become permissible under applicable State law, then the requirement that the assets of the organization revert to the State upon dissolution applies. Finally, the majority of the board of direc-tors (or comparable oversight body) of the organization must be ap-pointed by an official of the executive branch of the State or by the State legislature, or by both.

REASONS FOR CHANGE

The Committee understands that certain types of insurance to support governmental programs to prepare for or mitigate the ef-fects of natural catastrophic events (such as hurricanes) may be limited or unavailable at reasonable rates in the authorized insur-ance market in some States. The Committee believes it is appro-priate to provide tax-exempt status to certain types of associations that provide property and casualty insurance for windstorm, hail and fire damage to property located within a State if the State has determined that coverage in the authorized insurance market is in fact not reasonably available to a substantial number of insurable real properties.


The provision provides tax-exempt status for any association cre-ated before January 1, 1999, by State law and organized and oper-ated exclusively to provide property and casualty insurance cov-erage for windstorm, hail and fire damage to property located with-in the State for which the State has determined that coverage in the authorized insurance market is not reasonably available to a substantial number of insurable real properties, provided certain requirements are met.

Under the provision, no part of the net earnings of the associa-tion may inure to the benefit of any private shareholder or indi-vidual. Except as provided in the case of dissolution, no part of the assets of the association may be used for, or diverted to, any pur-pose other than: (1) to satisfy, in whole or in part, the liability of the association for, or with respect to, claims made on policies writ-ten by the association; (2) to invest in investments authorized by applicable law; (3) to pay reasonable and necessary administration expenses in connection with the establishment and operation of the association and the processing of claims against the association; or (4) to make remittances pursuant to State law to be used by the State to provide for the payment of claims on policies written by the association, purchase reinsurance covering losses under such policies, or to support governmental programs to prepare for or mitigate the effects of natural catastrophic events. The provision requires that the State law governing the association permit the association to levy assessments on insurance companies authorized to sell property and casualty insurance in the State, or on property and casualty insurance policyholders with insurable interests in property located in the State to fund deficits of the association, in-cluding the creation of reserves. The provision requires that the plan of operation of the association be subject to approval by the



chief executive officer or other official of the State, by the State leg-islature, or both. In addition, the provision requires that the assets of the association revert upon dissolution to the State, the State’s designee, or an entity designated by the State law governing the association, or that State law not permit the dissolution of the as-sociation.

The provision provides a special rule in the case of any entity or fund created before January 1, 1999, pursuant to State law and or-ganized and operated exclusively to receive, hold, and invest remit-tances from an association exempt from tax under the provision, to make disbursements to pay claims on insurance contracts issued by the association, and to make disbursements to support govern-mental programs to prepare for or mitigate the effects of natural catastrophic events. The special rule provides that the entity or fund may elect to be disregarded as a separate entity and be treat-ed as part of the association exempt from tax under the provision, from which it receives such remittances. The election is required to be made no later than 30 days following the date on which the as-sociation is determined to be exempt from tax under the provision, and would be effective as of the effective date of that determina-tion.

An organization described in the provision is treated as having unrelated business taxable income (‘‘UBIT’’) in the amount of its taxable income (computed as if the organization were not exempt from tax under the provision), if at the end of the immediately pre-ceding taxable year, the organization’s net equity exceeds 15 per-cent of the total coverage in force under insurance contracts issued by the organization and outstanding at the end of that preceding year.

Under the provision, no income or gain is recognized solely as a result of the change in status to that of an association exempt from tax under the provision.

EFFECTIVE DATE

The provision is effective for taxable years beginning after De-cember 31, 2002. No inference is intended as to the tax status under present law of associations described in the provision.

L. CONFORM PROVISIONS RELATING TO ARBITRAGE TREATMENT OF CERTAIN UNIVERSITY FUND TO STATE CONSTITUTIONAL AMEND-MENTS


PRESENT LAW

In general, present law tax-exempt arbitrage restrictions provide that interest on a State or local government bond is not eligible for tax-exemption if the proceeds are invested, directly or indirectly, in materially higher yielding investments or if the debt service on the bond is secured by or paid from (directly or indirectly) such invest-ments. An exception, enacted in 1984, provides that the pledge of income from investments in a permanent university fund (‘‘the Fund’’) established under a provision of a State constitution adopt-ed in 1876 as security for a limited amount of tax-exempt bonds will not cause interest on those bonds to be taxable. The terms of


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101 Sec. 7526.

this exception are limited to State constitutional or statutory re-strictions in effect as of October 9, 1969.

The Fund consists of certain State lands that were set aside for the benefit of higher education, the income from mineral rights to these lands, and certain other earnings on Fund assets. The State constitution directs that monies held in the Fund are to be invested in interest-bearing obligations and other securities. The constitu-tion does not permit the expenditure or mortgage of the Fund for any purpose. Income from the Fund is apportioned between two university systems operated by the State. Tax-exempt bonds issued by the two university systems are secured by and payable from the income of the Fund. These bonds are used to finance buildings and other permanent improvements for the universities.

The State constitutional rules governing the Fund have been modified with regard to the manner in which amounts in the Fund are paid for the benefit of the two university systems.

REASONS FOR CHANGE

The Committee understands that the State constitutional amend-ments have the effect of permitting the Fund to make annual dis-tributions in a manner similar to standard university endowment funds, rather than the previous practice which tied distributions to annual income performance, which can create a variable pattern of distributions. The Committee does not believe that the Fund should lose the benefits of the 1984 exception from the tax-exempt bond arbitrage restrictions by adopting a sounder, more modern ap-proach to the management of Fund distributions.


The 1984 exception is conformed to the present State constitu-tional provisions governing the Fund’s ability to make annual dis-tributions in a manner similar to standard university endowment funds. Limitations on the aggregate amount of bonds that may ben-efit from the exception are not modified.

EFFECTIVE DATE


M. MATCHING GRANTS TO LOW-INCOME TAXPAYER CLINICS FOR RETURN PREPARATION

(S(sec. 313 of the bill)

PRESENT LAW

The Secretary is authorized to provide up to $6 million per year in matching grants to certain low-income taxpayer clinics that rep-resent low-income taxpayers in controversies with the IRS or that operate programs to inform individuals for whom English is a sec-ond language about their tax-related rights and responsibilities.101



102 Treas. Reg. sec. 1.117–3(a). 103 Treas. Reg. sec. 1.117–4(c). 104 Secs. 4945(a) and (b). 105 Secs. 4945(d)(3) and (g). 106 For the purpose of section 4945(g), the term ‘‘scholarship or fellowship’’ refers to the provi-

sions of section 117(a) as in effect before the Tax Reform Act of 1986. Sec. 4945(g)(1). 107 Secs. 4945(g)(1) and 170(b)(1)(A)(ii).

REASONS FOR CHANGE

The Committee believes that the low-income taxpayer clinic pro-gram should be expanded to provide grants to assist low-income taxpayers in the preparation of their Federal tax returns.


The provision authorizes the Secretary to create a separate grant program to provide up to $10 million per year in matching grants to not for profit organizations that assist low-income taxpayers in the preparation of their Federal tax returns.

EFFECTIVE DATE


N. INCREASE PERCENTAGE LIMITS FOR CERTAIN EMPLOYER-RELATED SCHOLARSHIP PROGRAMS


PRESENT LAW

Gross income does not include any amount received as a quali-fied scholarship by an individual who is a candidate for a degree at an educational organization (sec. 117(a)). For this purpose, a scholarship generally means an amount paid or allowed to, or for the benefit of, a student to aid that student in pursuing studies.102 However, an amount paid or allowed to, or on behalf of, an indi-vidual to enable the individual to pursue studies is not treated as a scholarship if the amount represents compensation for past, present, or future services.103 The determination of whether an amount is properly treated as a scholarship or compensation for services is made in light of all the relevant facts and cir-cumstances.

Present law imposes excise taxes on the taxable expenditures of a private foundation.104 A taxable expenditure includes, among other things, any amount paid or incurred by a private foundation as a grant to an individual for travel, study, or other similar pur-poses by such individual, unless such grant is awarded on an objec-tive and nondiscriminatory basis pursuant to a procedure approved in advance by the Secretary.105 In the case of individual grants to be made as scholarships or fellowships, the private foundation must demonstrate to the satisfaction of the Secretary that the grant: (1) constitutes a scholarship or fellowship which would be subject to the provisions of section 117(a),106 and (2) is to be used for study at an educational organization which normally maintains a regular faculty and curriculum and normally has a regularly en-rolled body of pupils or students in attendance at the place where its educational activities are regularly carried on.107


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108 Rev. Proc. 76–47, 1976–2 C.B. 670. The revenue procedure defines an employer-related pro-gram as a program that treats some or all of the employees, or children of some or all of the employees, of an employer as a group from which grantees of some or all of the grants will be selected, limits the potential grantees from some or all of the grants to individuals who are em-ployees or children of employees of an employer, or otherwise gives such individuals a preference or priority over others in being selected as grantees.

109 The seven conditions include: (1) the program must not be used to recruit employees, to induce employees to continue their employment, or to compel a course of action sought by the employer; (2) the selection of grant recipients must be made by a committee consisting of inde-pendent individuals; (3) the program must impose identifiable minimum requirements for grant eligibility; (4) the selection of grant recipients must be based solely upon substantial objective standards that are completely unrelated to employment and to the employer’s line of business; (5) a grant may not be terminated because the recipient or the recipient’s parent terminates employment with the employer; (6) the courses of study for which grants are available must not be limited to those would be of particular benefit to the employer or the foundation; and (7) the terms of the grant and the courses of study for which grants are available must meet all other requirements of section 117 and must be consistent with the disinterested purpose of edu-cation for personal benefit rather than for the benefit of the employer or the foundation.

Private foundations may in the course of their activities make scholarship or fellowship grants to individuals to be used for edu-cational purposes. However, a private foundation’s grant program may not be designed or administered to the end of providing com-pensation, an employment incentive, or an employee fringe benefit to persons employed by the foundation or by another employer (in-cluding, for example, employees of a ‘‘related’’ employer organiza-tion). Revenue Procedure 76–47 provides advance approval guide-lines to determine whether grants made by private foundations under employer-related grant programs to an employee or to a child of an employee of the employer to which the program relates is considered a scholarship or fellowship grant subject to the provi-sions of section 117(a).108 To the extent that such grants are con-sidered scholarships or fellowships under these guidelines, the Sec-retary will assume the grants are not taxable expenditures subject to section 4945 taxes. Educational grants that are not scholarships or fellowships under these guidelines might, depending upon the circumstances, lead to a loss of the private foundation’s exempt sta-tus.

Under Revenue Procedure 76–47, a grant made under an em-ployer-related grant program that satisfies seven conditions and a percentage test is considered a scholarship or fellowship.109 Grants awarded to children of employees and to employees are considered as having been awarded under separate programs for purposes of the revenue procedure, regardless of whether they are awarded under separately administered programs. All such grants must sat-isfy each of the seven conditions to obtain advance approval of the grant program. The percentage test applicable to grants to children of employees requires that the number of grants awarded not ex-ceed either 25 percent of the eligible applicants considered by the selection committee in selecting grant recipients or 10 percent of those eligible for grants (regardless of whether they submitted grant applications). The percentage test applicable to grants to em-ployees requires that the number of grants awarded not exceed 10 percent of eligible applicants considered by the selection committee in selecting grant recipients. If the seven conditions are met, but the relevant percentage test is not satisfied, then the question of whether the grants constitute scholarships or fellowships is based upon all of the facts and circumstances.

Similar requirements and percentage limits apply to determine whether educational loans made by a private foundation under an



110 Rev. Proc. 80–39, 1980–2 C.B. 772. 111 Id.

employer-related loan program are taxable expenditures.110 If an employer-related program encompasses educational loans and scholarship or fellowship grants to the same group of eligible em-ployees or employees’ children, the percentage tests applicable to the loan program apply to the total number of individuals receiving combined grants of scholarships, fellowships, and educational loans.111

REASONS FOR CHANGE

The Committee believes that the quantitative limits set forth in Revenue Procedure 76–47 are too low for employer-related grant programs that provide scholarships or fellowships to children of employees. The Committee believes that higher percentage limits will encourage increases in grants made for educational purposes. The Committee also believes that the higher percentage limits should be available only in cases where the foundation maintains a comparable grant program for children who are not affiliated with the employer to which the employer-related grant program re-lates.


The percentage limits set forth in Revenue Procedure 76–47 for grants to children of employees are increased to 35 percent of eligi-ble applicants considered by the selection committee or 20 percent of those eligible for the grants. However, the higher percentage lim-its are available only if the private foundation meets the other re-quirements of the Revenue Procedure and demonstrates that the foundation provides a comparable number and aggregate amount of grants during the same grant-program year to children who are not children of former or current employees of any employer to which an employer-related grant program relates. The provision does not amend the percentage limits for grants to employees, or the per-centage limits of Revenue Procedure 80–39 relating to loan pro-grams or programs which encompass both loans and grants.

EFFECTIVE DATE

Revenue Procedure 76–47 is to be amended effective for grants awarded after December 31, 2002.

Title IV. Social Services Block Grant

(Secs. 401–403 of the bill)

PRESENT LAW

Social Services Block Grant Funding (‘‘SSBG’’), also known as ‘‘Title XX’’ (because it is Title XX of the Social Security Act), is a flexible funding stream, providing states with resources to support a variety of social services. SSBG funds can be used to assist the elderly and disabled so that they do not need to enter institutions, to prevent child and elder abuse, to provide child care, to promote and support adoption, and for several other services. There are cer-tain specified limitations so that SSBG cannot fund most medical


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care, for example, or cash welfare payments. It is a mandatory capped entitlement, distributed by a population-based formula among the states.

States use SSBG in differing ways. Much of the funding supports local social service providers, including faith-related organizations, through contracts with state and local governments. Overall, in fis-cal year 1999, SSBG spending was as follows: 13.4 percent for ‘‘pre-vention’’ and case management; 13 percent for day care; 12.4 per-cent for child and adult protective services; 10.9 percent for foster care; 7.4 percent for home-based services. There are several other categories in the expenditure data as well.

Prior to the 1996 welfare reform law, SSBG was funded at $2.8 billion. That legislation reduced SSBG to $2.38 billion, as part of achieving budgetary savings, and permitted states to transfer up to 10 percent of their new Temporary Assistance for Needy Families (TANF) welfare block grant allocations to SSBG. (Any transferred funds are required to be spent on behalf of families below 200 per-cent of poverty.) In 1998, as part of the TEA–21 highway legisla-tion, SSBG funding as further reduced, declining to $1.7 billion for fiscal year 2001 and fiscal year 2002. The TANF transfer was fur-ther limited to 4.25 percent.

REASONS FOR CHANGE

The Committee believes that an increase in funding for SSBG will allow social service organizations to provide more assistance to families in need and disadvantaged individuals. The flexible nature of SSBG permits states and localities to choose their own priorities for the uses of the increased funding.


The provision increases SSBG funding to $1.975 billion for fiscal year 2003 and $2.8 billion for fiscal year 2004. In addition, the TANF transfer limit is restored to 10 percent. These two measures provide additional resources to faith-related social service organiza-tions. Finally, the Secretary of HHS is required to submit annual reports on SSBG expenditures to the Congress.

EFFECTIVE DATE

The provision is effective for amounts made available for fiscal year 2003 and for amounts made available each fiscal year there-after. The provision requiring annual reports applies to such re-ports with respect to fiscal year 2002 and each fiscal year there-after.

Title V. Individual Development Accounts

(Secs. 501–511 of the bill)

PRESENT LAW

Individual development accounts were first authorized by the Personal Work and Responsibility Act of 1996. In 1998, the Assets for Independence Act established a five-year $125 million dem-onstration program to permit certain eligible individuals to open and make contributions to an individual development account. Con-tributions by an individual to an individual development account



112 Rev. Rul. 99–44, 1999–2 C.B. 549.

do not receive a tax preference but are matched by contributions from a State program, a participating nonprofit organization, or other ‘‘qualified entity.’’ The IRS has ruled that matching contribu-tions by a qualified entity are a gift and not taxable to the account owner.112 The qualified entity chooses a matching rate, which must be between 50 and 400 percent. Withdrawals from individual devel-opment accounts can be made for certain higher education ex-penses, a first home purchase, or small-business capitalization ex-penses. Matching contributions (and earnings thereon) typically are held separately from the individuals’ contributions (and earnings thereon) and must be paid directly to a mortgage provider, univer-sity, or business capitalization account at a financial institution. The Department of Health and Human Services administers the in-dividual development account program.

REASONS FOR CHANGE

The Committee recognizes that the rate of private savings in the United States is too low. In particular, many low-income individ-uals either have inadequate savings or no savings at all. The Com-mittee believes that a tax-subsidized match by financial institu-tions may help encourage more savings by low-income working in-dividuals. The program is intended to encourage a pattern of indi-vidual savings and wealth accumulation. Finally, the Committee believes that the program will allow individuals to use their sav-ings for three important purposes: (1) to afford better educations; (2) to achieve home ownership; and (3) to start their own busi-nesses.


The bill provides for a nonrefundable tax credit for an eligible en-tity (i.e., a qualified financial institution) that has an individual de-velopment account program in a taxable year. The tax credit equals the amount of matching contributions made by the eligible entity under the program (up to $500 per taxable year) plus $50 for each individual development account maintained during the taxable year under the program. Except in the first year that each account is open, the $50 credit is available only for accounts with a balance of more than $100 at year-end (including matching funds). No de-duction or other credit is available with respect to the amount of matching funds taken into account in determining the credit.

The credit applies with respect to the first 300,000 individual de-velopment accounts opened before January 1, 2011, and with re-spect to matching funds for participant contributions that are made after December 31, 2003, and before January 1, 2011. An account is considered open if at any time the balance in the account exceeds $100 (including matching amounts). The individual development accounts will be available on the following basis: (1) a maximum of 100,000 accounts may be opened after December 31, 2003 and before January 1, 2007; (2) a second 100,000 accounts may be opened after December 31, 2006 and before January 1, 2009, if the entire 100,000 of authorized accounts are opened after December 31, 2003 and before January 1, 2007 and the Secretary of the Treasury determines that these accounts are being reasonably and


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113 If less than 100,000 accounts are opened before January 1, 2007, then the number of ac-counts that can be opened after December 31, 2006 and before January 1, 2009 will be reduced to the lesser of 75,000 accounts of three times the number of accounts opened before January 1, 2007.

114 Married taxpayers filing separate returns are not eligible to open an IDA or to receive matching funds for an IDA that is already open.

responsibly administered;113 and (3) a third 100,000 accounts may be opened after December 31, 2008 and before January 1, 2011 if the previous cohorts of 100,000 accounts have been opened under the schedule described above and the Secretary of the Treasury makes a four-part determination. Specifically, the Secretary will have to determine: (1) that all previously opened accounts have been reasonably and responsibly administered to date; (2) that the individual development account program has increased net savings of participants in the program; (3) whether participants in the indi-vidual development account program have increased Federal in-come tax liability and decreased utilization of Federal assistance programs (e.g., Temporary Assistance to Needy Families and Food Stamps) relative to similarly situated individuals that did not par-ticipate in the individual development account program; and (4) that the sum of the increased Federal tax liability and reduction of Federal assistance program benefits to participants in the indi-vidual development account program is greater than the cost of the individual development account program to the Federal govern-ment. If the Secretary finds that any of the four determinations has not been satisfied, the Congress will have the discretion to au-thorize the third 100,000 accounts after the Secretary makes his or her report to the Congress regarding the four determinations. The third 100,000 accounts must be equally divided among the States. For all accounts, the Secretary will take steps to encourage use of individual development accounts in rural areas.

Nonstudent U.S. citizens or lawful permanent residents between the ages of 18 and 60 (inclusive) who meet certain income require-ments are eligible to open and contribute to an individual develop-ment account. The income limit for participation is modified ad-justed gross income of $18,000 for single filers, $38,000 for joint fil-ers, and $30,000 for head-of-household filers.114 Eligibility in a tax-able year generally is based on the previous year’s modified ad-justed gross income and circumstances (e.g., status as a student). Modified adjusted gross income is adjusted gross income plus cer-tain items that are not includible in gross income. The items added are tax-exempt interest and the amounts otherwise excluded from gross income under Code sections 86, 893, 911, 931, and 933 (relat-ing to the exclusion of certain social security and Tier 1 railroad retirement benefits; the exclusion of compensation of employees of foreign governments and international organizations; the exclusion of income of U.S. citizens or residents living abroad; the exclusion of income for residents of Guam, American Samoa, and the North-ern Mariana Islands; and the exclusion of income for residents of Puerto Rico). The income limits are adjusted for inflation after 2003. These amounts are rounded to the nearest multiple of 50 dol-lars.

Under the bill, an individual development account must: (1) be owned by the eligible individual for whom the account was estab-lished; (2) consist only of cash contributions; (3) be held by a person authorized to be a trustee of any individual retirement account



under section 408(a)(2); and (4) not commingle account assets with other property (except in a common trust fund or common invest-ment fund). These requirements must be reflected in the written governing instrument creating the account. The entity establishing the program is required to maintain separate accounts for the indi-vidual’s contributions (and earnings thereon) and for matching funds and earnings thereon (a ‘‘parallel account’’).

Contributions to individual development accounts by individuals are not deductible and earnings thereon are taxable to the account holder. Matching contributions and earnings thereon are not tax-able to the account holder.

The bill permits individuals to withdraw amounts from an indi-vidual development account for qualified expenses of the account owner, owner’s spouse, or dependents as well as for nonqualified expenses, subject to certain restrictions. Qualified expenses include qualified: (1) higher education expenses (as generally defined in section 529(e)(3)); (2) first-time homebuyer costs (as generally pro-vided in section 72 (t)(8)); (3) business capitalization or expansion costs (expenditures made pursuant to a business plan that has been approved by the financial institution); (4) rollovers of the bal-ance of the account (including the parallel account) to another indi-vidual development account for the benefit of the same owner; and (5) final distributions in the case of a deceased account owner. Withdrawals for qualified expenses must be made from funds that have been in the account for at least one year and must be paid directly to the unrelated third party to whom the amount is due, except in the case of expenses under a qualified business plan, roll-over, or final distribution. Such withdrawals generally are not per-mitted until the account owner completes a financial education course offered by a qualified financial institution. The Secretary of the Treasury (the ‘‘Secretary’’) is required to establish minimum standards for such courses. Withdrawals for nonqualified expenses may result in the account owner’s forfeiture of matching funds. The amount of the forfeiture is the lesser of: (1) an amount equal to the nonqualified withdrawal; or (2) the excess of the amount in the parallel account (excluding earnings on matching funds) over the amount remaining in the individual development account after the nonqualified withdrawal. If the individual development account (or a portion thereof) is pledged as security for a loan, then the portion so used will be treated as a nonqualified withdrawal and will result in the loss of an equal amount of matching funds from the parallel account.

The qualified entity administering the individual development account program generally is required to make quarterly payments of matching funds to a parallel account on a dollar-for-dollar basis for the first $500 contributed by the account owner in a taxable year. Matching funds also may be provided by State, local, or pri-vate sources. Balances of the individual development account and parallel account must be reported annually to the account owner. If an account owner ceases to meet eligibility requirements, match-ing funds generally may not be contributed during the period of in-eligibility. Any amount withdrawn from a parallel account is not includible in an eligible individual’s gross income or the account sponsor’s gross income.


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115 Temp. Treas. Reg. sec. 1.6011–4T; Prop. Treas. Reg. sec. 1.6011–4. Effective June 14, 2002, the regulations were modified to require non-corporate taxpayers (i.e., individuals, trusts, part-nerships, and S corporations) to disclose their participation in reportable transactions that have been specified by the Treasury Department as ‘‘listed’’ transactions. See T.D. 9000, 67 Fed. Reg. 41,324 (June 18, 2002). Disclosure of other reportable transactions under the regulations con-tinues to be limited to corporate taxpayers.

116 The recently-modified regulations clarify that the term ‘‘substantially similar’’ includes any transaction that is expected to obtain the same or similar types of tax benefits and that is either factually similar or based on the same or similar tax strategy. Also, the term must be broadly construed in favor of disclosure. See T.D. 9000, 67 Fed. Reg. 41,324 (June 18, 2002).

Qualified entities administering a qualified program are required to report to the Secretary that the program is administered in ac-cordance with legal requirements. If the Secretary determines that the program was not so operated, the Secretary would have the power to terminate the program. Qualified entities also are re-quired to report annually to the Secretary information about: (1) the number of individuals making contributions to individual devel-opment accounts; (2) the amounts contributed by such individuals; (3) the amount of matching funds contributed; (4) the amount of funds withdrawn and for what purpose; (5) balance information; and (6) any other information that the Secretary deems necessary. The fiduciary requirements of Title 12 of the United States Code with respect to insured depository institutions and insured credit unions (as defined therein) continue to apply to those financial in-stitutions participating in the individual development account pro-gram.

The Secretary is authorized to prescribe necessary regulations, including rules to permit individual development account program sponsors to verify eligibility of individuals seeking to open accounts and rules to allow a financial institution (e.g., a tax-exempt credit union) to transfer those credits to another taxpayer. The Secretary also is authorized to provide rules to recapture credits claimed with respect to individuals who forfeit matching funds.

The Secretary must submit annual reports to Congress on the status of the qualified individual account program.

EFFECTIVE DATE

The provision is effective for taxable years ending after December 31, 2003, and beginning before January 1, 2011.

Title VI. Revenue Provisions

A. TAX SHELTER TRANSPARENCY REQUIREMENTS

1. Penalty for failure to disclose reportable transactions (sec. 601 of the bill and new sec. 6707A of the Code)

PRESENT LAW

Regulations under section 6011 require a taxpayer to disclose with its tax return certain information with respect to each ‘‘report-able transaction’’ in which the taxpayer participates.115

There are two categories of reportable transactions. The first cat-egory includes any transaction that is the same as (or substantially similar to) 116 a transaction that is specified by the Treasury De-partment as a tax avoidance transaction whose tax benefits are subject to disallowance under present law (referred to as a ‘‘listed transaction’’). A taxpayer must disclose any listed transaction that



117 Temp. Treas. Reg. sec. 1.6011–4T(b)(2) and (b)(4)(i). 118 Temp. Treas. Reg. sec. 1.6011–4T(b)(3)(i)(A)–(E). In certain circumstances, a taxpayer can

avoid disclosure with respect to the second category of reportable transactions. See Temp. Treas. Reg. sec. 1.6011–4T(b)(3)(ii)(A)–(E).

119 Section 6664(c) provides that a taxpayer can avoid the imposition of a section 6662 accu-racy-related penalty in cases where the taxpayer can demonstrate that there was reasonable cause for the underpayment and that the taxpayer acted in good faith.

120 In this regard, the Committee has concerns with the outcomes and rationales used by courts in some recent decisions involving tax-motivated transactions. For a more detailed discus-sion of recent court decisions and other developments regarding tax shelters, see Joint Com-mittee on Taxation Background and Present Law Relating to Tax Shelters (JCX 19–02) March 19, 2002.

is expected to reduce the taxpayer’s Federal income tax liability by more than $1 million in any single taxable year or more than $2 million in any combination of years.117

The second category of reportable transactions includes trans-actions that are expected to reduce a taxpayer’s Federal income tax liability by more than $5 million in any single year or $10 million in any combination of years and that have at least two of the fol-lowing characteristics: (1) the taxpayer has participated in the transaction under conditions of confidentiality; (2) the taxpayer has obtained or been provided with contractual protection against the possibility that part or all of the intended tax benefits from the transaction will not be sustained; (3) the promoters of the trans-action have received or are expected to receive fees or other consid-eration with an aggregate value in excess of $100,000, and such fees are contingent on the taxpayer’s participation; (4) the trans-action results in a reported book/tax difference in excess of $5 mil-lion in any taxable year; or (5) the transaction involves a person that the taxpayer knows or has reason to know is in a Federal in-come tax position that differs from that of the taxpayer (such as a tax-exempt entity or foreign person), and the taxpayer knows or has reason to know that such difference has permitted the trans-action to be structured to provide the taxpayer with a more favor-able Federal income tax treatment.118

Under present law, there is no specific penalty for failing to dis-close a reportable transaction; however, such a failure may jeop-ardize the taxpayer’s ability to claim that any income tax under-statement attributable to such undisclosed transaction is due to reasonable cause, and that the taxpayer acted in good faith.119

The Committee is aware that individuals and corporations are increasingly using sophisticated transactions to avoid or evade Fed-eral income tax.120 Such a phenomenon could pose a serious threat to the efficacy of the tax system because of both the potential loss of revenue and the potential threat to the integrity of the self-as-sessment system.

The Committee over two years ago began working on legislation to address this significant compliance problem. In addition, the Treasury Department, using the tools available, issued regulations requiring disclosure of certain transactions and requiring orga-nizers and promoters of tax-engineered transactions to maintain customer lists and make these lists available to the IRS. Neverthe-less, the Committee believed that additional legislation was needed to provide the Treasury Department with additional tools to assist its efforts to curtail abusive transactions. In that regard, the Com-mittee issued for public comment three separate staff discussion drafts designed to address the tax shelter problem. The most recent


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121 See generally, ‘‘The Treasury Department’s Enforcement Proposals for Abusive Tax Avoid-ance Transactions,’’ released on March 20, 2002, reprinted electronically at 2002 TNT 55–28 (March 21, 2002).

draft (released in August 2001) focused on a regime that empha-sized disclosure of tax shelter transactions.

On March 21, 2002, the Committee heard testimony from Treas-ury Department and IRS officials that only 272 transactions by 99 different taxpayers were disclosed under the present law for the 2001 tax-filing season. In connection with the hearing, the Treas-ury Department announced a new initiative (the ‘‘Treasury shelter initiative’’) that is designed to provide the Treasury Department and the Internal Revenue Service (‘‘IRS’’) with the tools necessary to respond to abusive tax avoidance transactions.121 The Treasury shelter initiative emphasizes combating abusive transactions by re-quiring increased disclosure of such transactions by all parties in-volved. To facilitate such disclosure, the Treasury shelter initiative proposes clearer definitions to identify transactions that must be disclosed, and stiffer penalties for failure to disclose such trans-actions. The Treasury shelter initiative provides for

[A] series of clear, mutually reinforcing rules for disclo-sure, registration, and list maintenance. These rules will be easier for taxpayers and their advisors to apply, and harder for those who seek to avoid disclosure to manipu-late. * * * The Treasury Department’s proposals, for ex-ample, will broaden and align the rules and regulations for disclosure, registration, and list keeping under Sections 6011, 6111, and 6112 of the Code. * * * The Treasury De-partment’s enforcement initiative will create a single, clear definition of a transaction that must be disclosed and reg-istered, and for which lists must be maintained.

The Committee believes that the course of action outlined in the Treasury shelter initiative will bolster ongoing efforts to combat abusive tax avoidance transactions, and that encouraging greater disclosure of transactions with a potential for tax avoidance is ben-eficial to the tax system. Moreover, the Committee believes that a penalty for failing to make the required disclosures, when the im-position of such penalty is not dependent on the tax treatment of the underlying transaction ultimately being sustained, will provide an additional incentive for taxpayers to satisfy their reporting obli-gations under the new disclosure provisions.


In general The provision creates a new penalty for any person who fails to

include with any return or statement any required information with respect to a reportable transaction. The new penalty applies without regard to whether the transaction ultimately results in an understatement of tax, and applies in addition to any accuracy-re-lated penalty that may be imposed.



122 The provision states that, except as provided in regulations, a listed transaction means a reportable transaction, which is the same as, or similar to, a transaction specifically identified by the Secretary as a tax avoidance transaction for purposes of section 6011. The Committee anticipates that regulations under section 6011 will provide that a transaction is similar to a listed transaction if such transaction is expected to obtain the same or similar types of tax bene-fits and that is either factually similar or based on the same or similar tax strategy. The Sec-retary will have discretion to modify this definition as appropriate (as well as the definitions of reportable and listed transactions).

123 The Treasury shelter initiative stated that a reportable transaction would be defined as any transaction with any of the following characteristics: (1) any transaction specifically identi-fied by the IRS in published guidance as a tax avoidance transaction without regard to the size of the tax savings (i.e., a ‘‘ listed transaction’’), (2) certain loss transactions under section 165 in excess of $10 million for corporations, partnerships, and S corporations ($2 million for trusts and individuals), (3) any transaction resulting in a tax credit in excess of $250,000 if the tax-payer held the underlying asset for less than 45 days, (4) any book-tax difference of at least $10 million, subject to certain exceptions, and (5) any transaction marketed under conditions of confidentiality, if the transaction is expected to result in a reduction in taxable income of at least $250,000 ($500,000 in the case of a corporation).

Transactions to be disclosed The provision does not define the terms ‘‘listed transaction’’ 122 or

‘‘reportable transaction,’’ nor does the provision explain the type of information that must be disclosed in order to avoid the imposition of a penalty. Rather, the provision authorizes the Treasury Depart-ment to define a ‘‘listed transaction’’ and a ‘‘reportable transaction’’ under section 6011. As part of the Treasury shelter initiative, the Committee expects the Treasury Department to issue new regula-tions under section 6011 that will provide taxpayers with a set of objective standards to be applied in determining whether a tax-payer must disclose information regarding a particular transaction. The Committee anticipates that the new regulations will define a reportable transaction to include (but not be limited to) trans-actions with any of the following characteristics: (1) a significant loss, (2) a brief holding period, (3) a transaction that is marketed under conditions of confidentiality, (4) a transaction that is subject to indemnification agreements, or (5) a certain amount of book-tax difference.123

Disclosure requirements The Committee further expects that the new regulations will

specify the manner in which a taxpayer must disclose reportable transactions. The Committee anticipates that the information re-quired to be disclosed with respect to reportable transactions will be sufficiently detailed so as to provide the Treasury Department and IRS the ability to analyze all aspects of the transaction and de-termine an appropriate course of action (if any). To accomplish this objective, a taxpayer may be required to disclose the following in-formation with respect to a reportable transaction: (1) a detailed description of all facts relevant to the expected tax treatment of the reportable transaction (such as the structure of the transaction and the principal elements of the transaction), (2) a description and schedule of the expected tax benefits for all tax years resulting from the reportable transaction (including any anticipated trans-actions as part of the overall strategy), (3) if applicable, the names and addresses of any party who promoted, solicited, or rec-ommended the taxpayer’s participation in the transaction and who had a financial interest (including the receipt of fees) in the tax-payer’s decision to participate, and (4) other information that the Secretary may prescribe (e.g., the involvement of any accommoda-tion party or any tax-indifferent party, the receipt of a tax opinion


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124 The Committee recognizes that the Secretary’s present-law authority to postpone certain tax-related deadlines because of Presidentially-declared disasters (sec. 7508A) will also encom-pass the authority to postpone the reporting deadlines established by the provision.

125 This category of transactions is described in greater detail below in connection with the provision modifying the accuracy-related penalty to tax shelters.

with respect to the transaction, the amount of any fees paid to any promoter or advisor in connection with the transaction, any antici-pated subsequent transactions or exit strategies).

The Committee intends that, in accordance with section 6065 (re-lating to verification of returns), the form the Secretary prescribes for taxpayer disclosure of reportable transactions will include a written declaration that the information is being provided under penalties of perjury. Moreover, the Committee intends that the verification under penalties of perjury also will apply to any large entity that discloses that it did not enter into any reportable trans-actions during the tax year covered by such declaration.

Penalty rate The penalty for failing to disclose a reportable transaction is

$50,000. The amount is increased to $100,000 if the failure is with respect to a listed transaction. For large entities and high net worth individuals, the penalty amount is doubled (i.e., $100,000 for a reportable transaction and $200,000 for a listed transaction). The penalty cannot be waived with respect to a listed transaction. As to reportable transactions, the penalty can be rescinded or abated only in exceptional circumstances.124 All or part of the penalty may be rescinded only if: (1) the taxpayer on whom the penalty is im-posed has a history of complying with the Federal tax laws, (2) it is shown that the violation is due to an unintentional mistake of fact, (3) imposing the penalty would be against equity and good conscience, and (4) rescinding the penalty would promote compli-ance with the tax laws and effective tax administration. The au-thority to rescind the penalty can only be exercised by the Commis-sioner personally or the head of the Office of Tax Shelter Analysis; this authority to rescind cannot otherwise be delegated by the Commissioner. Thus, the penalty cannot be rescinded by a revenue agent, an appeals officer, or other IRS personnel. The decision to rescind a penalty must be accompanied by a record describing the facts and reasons for the action and the amount rescinded. There will be no taxpayer right to appeal a refusal to rescind a penalty. The IRS also is required to submit an annual report to Congress summarizing the application of the disclosure penalties and pro-viding a description of each penalty rescinded under this provision and the reasons for the rescission.

A ‘‘large entity’’ is defined as any entity with gross receipts in ex-cess of $10 million in the year of the transaction or in the pre-ceding year. A ‘‘high net worth individual’’ is defined as any indi-vidual whose net worth exceeds $2 million, based on the fair mar-ket value of the individual’s assets and liabilities immediately be-fore entering into the transaction.

A public entity that is required to pay a penalty for failing to dis-close a listed transaction (or is subject to an accuracy-related pen-alty for a nondisclosed listed transaction or a nondisclosed report-able transaction with a significant tax avoidance purpose 125) must disclose the imposition of the penalty in reports to the Securities



126 Sec. 6662. 127 Sec. 6662(d)(2)(B). 128 Sec. 6662(d)(2)(C).129 Sec. 6664(c).

and Exchange Commission (‘‘SEC’’) for such period as the Secretary shall specify. The provision applies without regard to whether the taxpayer determines the amount of the penalty to be material to the reports in which the penalty must appear, and treats any fail-ure to disclose a transaction in such reports as a failure to disclose a listed transaction. A taxpayer must disclose a penalty in reports to the SEC once the taxpayer has exhausted its administrative and judicial remedies with respect to the penalty (or if earlier, when paid).

As described above in connection with present law, current regu-lations under section 6011 require the disclosure of certain report-able transactions. Until such regulations are modified to reflect the new categories of reportable transactions, the penalty will apply to taxpayers who fail to timely disclose any reportable transaction under the definitions contained in the current regulations.

EFFECTIVE DATE

The provision is effective for returns and statements the due date for which is after the date of enactment.

2. Modifications to the accuracy-related penalties for listed trans-actions and reportable transactions having a significant tax avoid-ance purpose (sec. 602 of the bill and new sec. 6662A and secs. 6662 and 6664 Of the Code)

PRESENT LAW

The accuracy-related penalty applies to the portion of any under-payment that is attributable to (1) negligence, (2) any substantial understatement of income tax, (3) any substantial valuation misstatement, (4) any substantial overstatement of pension liabil-ities, or (5) any substantial estate or gift tax valuation understate-ment. If the correct income tax liability exceeds that reported by the taxpayer by the greater of 10 percent of the correct tax or $5,000 ($10,000 in the case of corporations), then a substantial un-derstatement exists and a penalty may be imposed equal to 20 per-cent of the underpayment of tax attributable to the understate-ment.126 The amount of any understatement generally is reduced by any portion attributable to an item if (1) the treatment of the item is supported by substantial authority, or (2) facts relevant to the tax treatment of the item were adequately disclosed and there was a reasonable basis for its tax treatment.127

Special rules apply with respect to tax shelters.128 For under-statements by non-corporate taxpayers attributable to tax shelters, the penalty may be avoided only if the taxpayer establishes that, in addition to having substantial authority for the position, the tax-payer reasonably believed that the treatment claimed was more likely than not the proper treatment of the item. This reduction in the penalty is unavailable to corporate tax shelters.

The understatement penalty generally is abated (even with re-spect to tax shelters) in cases in which the taxpayer can dem-onstrate that there was ‘‘reasonable cause’’ for the underpayment and that the taxpayer acted in good faith.129 The relevant regula-


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130 Treas. Reg. sec. 1.6662–4(g)(4)(i)(B); Treas. Reg. sec. 1.6664–4(c). 131 See ‘‘The Treasury Department’s Enforcement Proposals for Abusive Tax Avoidance Trans-

actions,’’ at 12 (released on March 20, 2002), reprinted electronically at 2002 TNT 55–28 (March 21, 2002).

132 The terms ‘‘reportable transaction’’ and ‘‘listed transaction’’ have the same meanings as previously described in connection with the penalty for failing to disclose a reportable trans-action.

tions provide that reasonable cause exists where the taxpayer ‘‘rea-sonably relies in good faith on an opinion based on a professional tax advisor’s analysis of the pertinent facts and authorities [that] * * * unambiguously concludes that there is a greater than 50-per-cent likelihood that the tax treatment of the item will be upheld if challenged’’ by the IRS.130

REASONS FOR CHANGE

The Committee understands that taxpayers are being advised not to disclose tax avoidance transactions on the grounds that any accuracy-related penalty that could result from an underpayment of tax on such a transaction can be avoided.131 Because the Treas-ury shelter initiative emphasizes combating abusive tax avoidance transactions by requiring increased disclosure of such transactions by all parties involved, the Committee believes that taxpayers should be subject to a strict liability penalty on an understatement of tax that is attributable to non-disclosed listed transactions or non-disclosed reportable transactions that have a significant pur-pose of tax avoidance. Furthermore, in order to deter taxpayers from entering into tax avoidance transactions, the Committee be-lieves that a more meaningful (but less stringent) accuracy-related penalty should apply to such transactions even when disclosed.


In general The provision modifies the present-law accuracy related penalty

by replacing the rules applicable to tax shelters with a new accu-racy-related penalty that applies to listed transactions and report-able transactions with a significant tax avoidance purpose (herein-after referred to as a ‘‘reportable avoidance transaction’’).132 The penalty rate and the taxpayer defenses available to avoid the pen-alty vary depending on the category of the transaction (i.e., listed or reportable avoidance transaction) and whether the transaction was adequately disclosed.

In general, a 20-percent accuracy-related penalty is imposed on any understatement attributable to a listed transaction or a report-able avoidance transaction. The only exception to the penalty is if the taxpayer satisfies a more stringent reasonable cause and good faith exception (hereinafter referred to as the ‘‘strengthened rea-sonable cause exception’’), which is described below. The strength-ened reasonable cause exception is available only if the relevant facts affecting the tax treatment are adequately disclosed, there is or was substantial authority for the claimed tax treatment, and the taxpayer reasonably believed that the claimed tax treatment was more likely than not the proper treatment.

If the taxpayer does not adequately disclose the transaction, the strengthened reasonable cause exception is not available (i.e., a no-fault penalty applies), and the taxpayer is subject to an increased



133 For this purpose, any reduction in the excess of deductions allowed for the taxable year over gross income for such year, and any reduction in the amount of capital losses which would (without regard to section 1211) be allowed for such year, shall be treated as an increase in taxable income.

134 See the previous discussion regarding the penalty for failing to disclose a reportable trans-action.

penalty rate. If the understatement is attributable to an undis-closed listed transaction, the penalty rate is increased to 30 percent of the understatement. For understatements attributable to an un-disclosed reportable avoidance transaction, the penalty rate is 25 percent of the understatement.

Determination of the understatement amount The penalty is applied to the amount of any understatement at-

tributable to the listed or reportable avoidance transaction without regard to other items on the tax return. For purposes of this provi-sion, the amount of the understatement is determined as the sum of (1) the product of the highest corporate or individual tax rate (as appropriate) and the increase in taxable income resulting from the difference between the taxpayer’s treatment of the item and the proper treatment of the item (without regard to other items on the tax return),133 and (2) the amount of any decrease in the aggregate amount of credits which results from a difference between the tax-payer’s treatment of an item and the proper tax treatment of such item.

Except as provided in regulations, the taxpayer’s treatment of an item shall not take into account any amendment or supplement to a return if the amendment or supplement is filed after the earlier of when the taxpayer is first contacted regarding an examination of the return or such other date as specified by the Secretary.

Strengthened reasonable cause exception A penalty is not imposed under the provision with respect to any

portion of an understatement if it is shown that there was reason-able cause for such portion and the taxpayer acted in good faith. Such a showing requires (1) adequate disclosure of the facts affect-ing the transaction in accordance with the regulations under sec-tion 6011,134 (2) there is or was substantial authority for such treatment, and (3) the taxpayer reasonably believed that such treatment was more likely than not the proper treatment. For this purpose, a taxpayer will be treated as having a reasonable belief with respect to the tax treatment of an item only if such belief (1) is based on the facts and law that exist at the time the tax return (that includes the item) is filed, and (2) relates solely to the tax-payer’s chances of success on the merits and does not take into ac-count the possibility that (a) a return will not be audited, (b) the treatment will not be raised on audit, or (c) the treatment will be resolved through settlement if raised.

A taxpayer may (but is not required to) rely on an opinion of a tax advisor in establishing its reasonable belief with respect to the tax treatment of the item. However, a taxpayer may not rely on an opinion of a tax advisor for this purpose if the opinion (1) is pro-vided by a ‘‘disqualified tax advisor,’’ or (2) is a ‘‘disqualified opin-ion.’’


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135 The term ‘‘material advisor’’ (defined below in connection with the new information filing requirements for material advisors) means any person who provides any material aid, assist-ance, or advice with respect to organizing, promoting, selling, implementing, or carrying out any reportable transaction, and who derives gross income in excess of $50,000 in the case of a re-portable transaction substantially all of the tax benefits from which are provided to natural per-sons ($250,000 in any other case).

136 This situation could arise, for example, when an advisor has an arrangement or under-standing (oral or written) with an organizer, manager, or promoter of a reportable transaction that such party will recommend or refer potential participants to the advisor for an opinion re-garding the tax treatment of the transaction.

137 An advisor should not be treated as participating in the organization of a transaction if the advisor’s only involvement with respect to the organization of the transaction is the ren-dering of an opinion regarding the tax consequences of such transaction. However, such an advi-sor may be a ‘‘disqualified tax advisor’’ with respect to the transaction if the advisor participates in the management, promotion or sale of the transaction (or if the material advisor is com-pensated by another material advisor, has a fee arrangement that is contingent on the tax bene-fits of the transaction, or as determined by the Secretary, has a continuing financial interest with respect to the transaction).

Disqualified tax advisor A disqualified tax advisor is any material advisor 135 who (1) par-

ticipates in the organization, management, promotion or sale of the transaction or is related (within the meaning of section 267 or 707) to any person who so participates, (2) is compensated by another material advisor with respect to the transaction, (3) has a fee ar-rangement with respect to the transaction that is contingent on all or part of the intended tax benefits from the transaction being sus-tained, or (4) as determined under regulations prescribed by the Secretary, has a continuing financial interest with respect to the transaction.136

Organization, management, promotion or sale of a trans-action

The Committee intends that a material advisor be considered as participating in the ‘‘organization’’ of a transaction if the advisor performs acts relating to the development of the transaction. This may include, for example, preparing documents (1) establishing a structure used in connection with the transaction (such as a part-nership agreement), (2) describing the transaction (such as an of-fering memorandum or other statement describing the transaction), or (3) relating to the registration of the transaction with any fed-eral, state or local government body.137 Participation in the ‘‘man-agement’’ of a transaction means involvement in the decision-mak-ing process regarding any business activity with respect to the transaction. Participation in the ‘‘promotion or sale’’ of a trans-action means involvement in the marketing or solicitation of the transaction to others. Thus, an advisor who provides information about the transaction to a potential participant is involved in the promotion or sale of a transaction, as is any advisor who rec-ommends the transaction to a potential participant.

Disqualified opinion An opinion may not be relied upon if the opinion (1) is based on

unreasonable factual or legal assumptions (including assumptions as to future events), (2) unreasonably relies upon representations, statements, finding or agreements of the taxpayer or any other per-son, (3) does not identify and consider all relevant facts, or (4) fails to meet any other requirement prescribed by the Secretary.



138 Sec. 6662(a) and (d)(1)(A).139 Sec. 6662(d)(2)(B). 40 Sec. 6662(d)(2)(D)

Coordination with other penalties Any understatement to which a penalty is imposed under this

provision is not subject to the accuracy-related penalty under sec-tion 6662. However, such understatement is included for purposes of determining whether any understatement (as defined in sec. 6662(d)(2)) is a substantial understatement as defined under sec-tion 6662(d)(1).

The penalty imposed under this provision shall not apply to any portion of an understatement to which a fraud penalty is applied under section 6663.

EFFECTIVE DATE

The provision is effective for taxable years ending after the date of enactment.

3. Modifications to the substantial understatement penalty (sec. 603 of the bill and sec. 6662 of the Code)

PRESENT LAW

Definition of substantial understatement An accuracy-related penalty equal to 20 percent applies to any

substantial understatement of tax. A ‘‘substantial understatement’’ exists if the correct income tax liability for a taxable year exceeds that reported by the taxpayer by the greater of 10 percent of the correct tax or $5,000 ($10,000 in the case of most corporations).138

Reduction of understatement for certain positions For purposes of determining whether a substantial understate-

ment penalty applies, the amount of any understatement generally is reduced by any portion attributable to an item if (1) the treat-ment of the item is supported by substantial authority, or (2) facts relevant to the tax treatment of the item were adequately disclosed and there was a reasonable basis for its tax treatment.139

The Secretary is required to publish annually in the Federal Reg-ister a list of positions for which the Secretary believes there is not substantial authority and which affect a significant number of tax-payers.140

REASONS FOR CHANGE

The Committee believes that the present-law definition of sub-stantial understatement allows large corporate taxpayers to avoid the accuracy-related penalty on questionable transactions of a sig-nificant size. The Committee believes that an understatement of more than $10 million is substantial in and of itself, regardless of the proportion it represents of the taxpayer’s total tax liability.

The Committee believes that a higher compliance standard should be imposed on any taxpayer in order to reduce the amount of an understatement resulting from a transaction that the tax-payer did not adequately disclose. The Committee further believes that a taxpayer should not take a position on a tax return that could give rise to a substantial understatement penalty that the


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taxpayer does not believe is more likely than not the correct tax treatment unless this information is disclosed to the IRS.


Definition of substantial understatement The provision modifies the definition of ‘‘substantial’’ for cor-

porate taxpayers. Under the provision, a corporate taxpayer has a subs

tantial understatement if the amount of the understatement for the taxable year exceeds the lesser of (1) 10 percent of the tax re-quired to be shown on the return for the taxable year (or, if great-er, $10,000), or (2) $10 million.

Reduction of understatement for certain positions The provision elevates the standard that a taxpayer must satisfy

in order to reduce the amount of an understatement for undisclosed items. With respect to the treatment of an item whose facts are not adequately disclosed, a resulting understatement is reduced only if the taxpayer had a reasonable belief that the tax treatment was more likely than not the proper treatment. The provision also au-thorizes (but does not require) the Secretary to publish a list of po-sitions for which it believes there is not substantial authority or there is no reasonable belief that the tax treatment is more likely than not the proper treatment (without regard to whether such po-sitions affect a significant number of taxpayers). The list shall be published in the Federal Register or the Internal Revenue Bulletin.

EFFECTIVE DATE

The provision is effective for taxable years beginning after date of enactment.

4. Tax shelter exception to confidentiality privileges relating to tax-payer communications (sec. 604 of the bill and sec. 7525 of the Code)

PRESENT LAW

In general, a common law privilege of confidentiality exists for communications between an attorney and client with respect to the legal advice the attorney gives the client. The Code provides that, with respect to tax advice, the same common law protections of confidentiality that apply to a communication between a taxpayer and an attorney also apply to a communication between a taxpayer and a federally authorized tax practitioner to the extent the com-munication would be considered a privileged communication if it were between a taxpayer and an attorney. This rule is inapplicable to communications regarding corporate tax shelters.

REASONS FOR CHANGE

The Committee believes that the rule currently applicable to cor-porate tax shelters should be applied to all tax shelters, regardless of whether or not the participant is a corporation.



141 Sec. 6111(A) 142 The tax shelter ratio is, with respect to any year, the ratio that the aggregate amount of

the deductions and 350 percent of the credits, which are represented to be potentially allowable to any investor, bears to the investment base (money plus basis of assets contributed) as of the close of the tax year.

143 Sec. 6111(c). 144Sec. 6111(d). 145 Temp. Treas. Reg. sec. 301.6111–2T(b)(2). 146 Temp. Treas. Reg. sec. 301.6111–2T(b)(3). 147 Temp. Treas. Reg. sec. 301.6111–2T(b)(4).


The bill modifies the rule relating to corporate tax shelters by making it applicable to all tax shelters, whether entered into by corporations, individuals, partnerships, tax-exempt entities, or any other entity. Accordingly, communications with respect to tax shel-ters are not subject to the confidentiality provision of the Code that otherwise applies to a communication between a taxpayer and a federally authorized tax practitioner.

EFFECTIVE DATE

The provision is effective with respect to communications made on or after the date of enactment.

5. Disclosure of reportable transactions by material advisors (secs. 611 and 612 of the bill and secs. 6111 and 6707 of the Code)

PRESENT LAW

Registration of tax shelter arrangements An organizer of a tax shelter is required to register the shelter

with the Secretary not later than the day on which the shelter is first offered for sale.141 A ‘‘tax shelter’’ means any investment with respect to which the tax shelter ratio 142 for any investor as of the close of any of the first five years ending after the investment is offered for sale may be greater than two to one and which is: (1) required to be registered under Federal or State securities laws, (2) sold pursuant to an exemption from registration requiring the fil-ing of a notice with a Federal or State securities agency, or (3) a substantial investment (greater than $250,000 and at least five in-vestors).143

Other promoted arrangements are treated as tax shelters for purposes of the registration requirement if: (1) a significant pur-pose of the arrangement is the avoidance or evasion of Federal in-come tax by a corporate participant; (2) the arrangement is offered under conditions of confidentiality; and (3) the promoter may re-ceive fees in excess of $100,000 in the aggregate.144

A transaction has a ‘‘significant purpose of avoiding or evading Federal income tax’’ if the transaction: (1) is the same as or sub-stantially similar to a ‘‘listed transaction,’’ 145 or (2) is structured to produce tax benefits that constitute an important part of the in-tended results of the arrangement and the promoter reasonably ex-pects to present the arrangement to more than one taxpayer.146 Certain exceptions are provided with respect to the second category of transactions.147

An arrangement is offered under conditions of confidentiality if: (1) an offeree has an understanding or agreement to limit the dis-closure of the transaction or any significant tax features of the


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148 The regulations provide that the determination of whether an arrangement is offered under conditions of confidentiality is based on all the facts and circumstances surrounding the offer. If an offeree’s disclosure of the structure or tax aspects of the transaction are limited in any way by an express or implied understanding or agreement with or for the benefit of a tax shelter promoter, an offer is considered made under conditions of confidentiality, whether or not such understanding or agreement is legally binding. Treas. Reg. sec. 301.6111–2T(c)(1).

149 Sec. 6707. 150The Treasury Department’s enforcement proposals for abusive tax avoidance transactions

are described in greater detail above in connection with the penalty for failing to disclose report-able transactions (new sec. 6707A).

151 The terms ‘‘reportable transaction’’ and ‘‘listed transaction’’ have the same meaning as pre-viously described in connection with the taxpayer-related provisions.

transaction; or (2) the promoter claims, knows, or has reason to know that a party other than the potential participant claims that the transaction (or any aspect of it) is proprietary to the promoter or any party other than the offeree, or is otherwise protected from disclosure or use.148

Failure to register tax shelter The penalty for failing to timely register a tax shelter (or for fil-

ing false or incomplete information with respect to the tax shelter registration) generally is the greater of one percent of the aggre-gate amount invested in the shelter or $500.149 However, if the tax shelter involves an arrangement offered to a corporation under con-ditions of confidentiality, the penalty is the greater of $10,000 or 50 percent of the fees payable to any promoter with respect to of-ferings prior to the date of late registration. Intentional disregard of the requirement to register increases the penalty to 75 percent of the applicable fees.

Section 6707 also imposes (1) a $100 penalty on the promoter for each failure to furnish the investor with the required tax shelter identification number, and (2) a $250 penalty on the investor for each failure to include the tax shelter identification number on a return.

REASONS FOR CHANGE

The Committee has been advised that the current promoter reg-istration rules have not proven particularly helpful, because the rules are not appropriate for the kinds of abusive transactions now prevalent, and because the limitations regarding confidential cor-porate arrangements have proven easy to circumvent.

The Committee believes that providing a single, clear definition regarding the types of transactions that must be disclosed by tax-payers and material advisors (as outlined in the Treasury shelter initiative), coupled with more meaningful penalties for failing to disclose such transactions, are necessary tools if the effort to curb the use of abusive tax avoidance transactions is to be effective.150


Disclosure of reportable transactions by material advisors The provision repeals the present law rules with respect to reg-

istration of tax shelters. Instead, the provision requires each mate-rial advisor with respect to any reportable transaction 151 to timely file an information return with the Secretary (in such form and manner as the Secretary may prescribe). The return must be filed on such date as specified by the Secretary.



152 See the previous discussion regarding the disclosure requirements under new section 6707A.

153 The terms ‘‘reportable transaction’’ and ‘‘listed transaction’’ have the same meaning as pre-viously described in connection with the taxpayer-related provisions.

154 The Committee recognizes that the Secretary’s present-law authority to postpone certain tax-related deadlines because of Presidentially-declared disasters (sec. 7508A) will also encom-pass the authority to postpone the reporting deadlines established by the provision.

The information return will include (1) information identifying and describing the transaction, (2) information describing any po-tential tax benefits expected to result from the transaction, and (3) such other information as the Secretary may prescribe. It is ex-pected that the Secretary may seek from the material advisor the same type of information that the Secretary may request from a taxpayer in connection with a reportable transaction.152

A ‘‘material advisor’’ means any person (1) who provides material aid, assistance, or advice with respect to organizing, promoting, selling, implementing, or carrying out any reportable transaction, and (2) who directly or indirectly derives gross income in excess of $250,000 ($50,000 in the case of a reportable transaction substan-tially all of the tax benefits from which are provided to natural per-sons) for such advice or assistance.

The Secretary may prescribe regulations which provide (1) that only one material advisor has to file an information return in cases in which two or more material advisors would otherwise be re-quired to file information returns with respect to a particular re-portable transaction, (2) exemptions from the requirements of this section, and (3) other rules as may be necessary or appropriate to carry out the purposes of this section.

Penalty for failing to furnish information regarding reportable transactions

The provision repeals the present law penalty for failure to reg-ister tax shelters. Instead, the provision imposes a penalty on any material advisor who fails to file an information return with re-spect to any reportable transaction, or who files a false or incom-plete information return with the Secretary with respect to a re-portable transaction.153 The amount of the penalty is $50,000. If the penalty is with respect to a listed transaction, the amount of the penalty is increased to the greater of (1) $200,000, or (2) 50 percent of the gross income of such person with respect to aid, as-sistance, or advice which is provided with respect to the reportable transaction before the date the information return that includes the transaction is filed. Intentional disregard by a material advisor of the requirement to disclose a reportable transaction increases the penalty to 75 percent of such gross income.

The penalty cannot be waived with respect to a listed trans-action. As to reportable transactions, the penalty can be rescinded or abated only in exceptional circumstances.154 All or part of the penalty may be rescinded only if: (1) the material advisor on whom the penalty is imposed has a history of complying with the Federal tax laws, (2) it is shown that the violation is due to an uninten-tional mistake of fact, (3) imposing the penalty would be against equity and good conscience, and (4) rescinding the penalty would promote compliance with the tax laws and effective tax administra-tion. The authority to rescind the penalty can only be exercised by the Commissioner personally or the head of the Office of Tax Shel-


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155 Sec. 6112. 156 See Temp. Treas. Reg. sec. 301.6112–1T Q&A 17. 157 See Temp. Treas. Reg. sec. 301–6112–1T Q&A 8. 158 Sec. 6112(c)(2).

ter Analysis; this authority to rescind cannot otherwise be dele-gated by the Commissioner. Thus, the penalty cannot be rescinded by a revenue agent, an appeals officer, or other IRS personnel. The decision to rescind a penalty must be accompanied by a record de-scribing the facts and reasons for the action and the amount re-scinded. There will be no right to appeal a refusal to rescind a pen-alty. The IRS also is required to submit an annual report to Con-gress summarizing the application of the disclosure penalties and providing a description of each penalty rescinded under this provi-sion and the reasons for the rescission.

EFFECTIVE DATE

The provision requiring disclosure of reportable transactions by material advisors applies to transactions with respect to which ma-terial aid, assistance or advice is provided after the date of enact-ment.

The provision imposing a penalty for failing to disclose reportable transactions applies to returns the due date for which is after the date of enactment.

6. Investor lists and applicable penalties (secs. 611 and 613 of the bill and secs. 6112 and 6708 of the Code)

PRESENT LAW

Investor lists A promoter must maintain (for a period of seven years) a list

identifying each person who was sold an interest in any tax shelter with respect to which registration was required under section 6111 (even though the particular party may not have been subject to confidentiality restrictions).155 Regulations under section 6112 pro-vide that, in addition to the name, tax shelter identification num-ber and other identifying information the promoter must include detailed information about the tax shelter (including details of the shelter and the expected tax benefits, as well as copies of any addi-tional written material given to any participant or advisor).156 A limited exception is provided for certain shelters if the total fees are less than $25,000 or if the expected reduction in tax liabilities for any single year is less than $1 million for corporations or $250,000 for non-corporate taxpayers.157 The Secretary is required to prescribe regulations which provide that, in cases in which 2 or more persons are required to maintain the same list, only one per-son would be required to maintain the list.158

Penalties for failing to maintain investor lists Under section 6708, the penalty for failing to maintain the list

required under section 6112 is $50 for each name omitted from the list (with a maximum penalty of $100,000 per year).



159 The Treasury Department’s enforcement proposals for abusive tax avoidance transactions are described in greater detail above in connection with the penalty for failing to disclose report-able transactions (new sec. 6707A).

160 The term ‘‘material advisor’’ has the same meaning as when used in connection with the requirement to file an information return under section 6111.

161 The term ‘‘reportable transaction’’ has the same meaning as previously described in connec-tion with the taxpayer-related provisions.

162 In no event will failure to maintain a list be considered reasonable cause for failing to make a list available to the Secretary.

REASONS FOR CHANGE

The Committee has been advised that the present-law penalties for failure to maintain customer lists are not meaningful and that promoters often have refused to provide requested information to the IRS. The Committee believes that requiring material advisors to maintain a list of advisees with respect to each reportable trans-action, coupled with more meaningful penalties for failing to main-tain an investor list, are important tools in the ongoing efforts to curb the use of abusive tax avoidance transactions. Furthermore, these provisions are consistent with the course of action outlined in the Treasury shelter initiative.159


Investor lists Each material advisor 160 that is required to file an information

return with respect to a reportable transaction 161 is required to maintain a list that (1) identifies each person with respect to whom the advisor acted as a material advisor with respect to the report-able transaction, and (2) contains other information as may be re-quired by the Secretary. In addition, the provision authorizes (but does not require) the Secretary to prescribe regulations which pro-vide that, in cases in which 2 or more persons are required to maintain the same list, only one person would be required to main-tain the list.

Penalty for failing to maintain investor lists The provision modifies the penalty for failing to maintain the re-

quired list by making it a time-sensitive penalty. Thus, a material advisor who is required to maintain an investor list and who fails to make the list available upon request by the Secretary within 20 business days after the request will be subject to a $10,000 per day penalty. The penalty applies to a person who fails to maintain a list, maintains an incomplete list, or has in fact maintained a list but does not make the list available to the Secretary. The penalty can be waived if the failure to make the list available is due to rea-sonable cause.162

EFFECTIVE DATE

The provision requiring a material advisor to maintain an inves-tor list applies to transactions with respect to which material aid, assistance or advice is provided after the date of enactment.

The provision imposing a penalty for failing to maintain investor lists applies to requests made after the date of enactment.


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163 Sec. 7408. 164 Sec. 6707, as amended by other provisions of this bill. 165 Sec. 6708, as amended by other provisions of this bill.

7. Actions to enjoin conduct with respect to tax shelters (sec. 614 of the bill and sec. 7408 of the Code)

PRESENT LAW

The Code authorizes civil action to enjoin any person from pro-moting abusive tax shelters or aiding or abetting the understate-ment of tax liability.163

REASONS FOR CHANGE

The Committee understands that some promoters are blatantly ignoring the rules regarding registration and list maintenance re-gardless of the penalties. An injunction would place these pro-moters in a public proceeding under court order. Thus, the Com-mittee believes that the types of tax shelter activities with respect to which an injunction may be sought should be expanded.


The bill expands this rule so that injunctions may also be sought with respect to the requirements relating to the reporting of tax shelters 164 and the keeping of lists of investors by material advi-sors.165 Thus, under the provision, an injunction may be sought against a material advisor to enjoin the advisor from (1) failing to file an information return with respect to a reportable transaction, or (2) failing to maintain, or to timely furnish upon written request by the Secretary, a list of investors with respect to each reportable transaction.

EFFECTIVE DATE

The provision is effective on the day after the date of enactment.

8. Understatement of taxpayer’s liability by income tax return pre-parer (sec. 621 of the bill and sec. 6694 of the Code)

PRESENT LAW

An income tax return preparer who prepares a return with re-spect to which there is an understatement of tax that is due to a position for which there was not a realistic possibility of being sus-tained on its merits and the position was not disclosed (or was friv-olous) is liable for a penalty of $250, provided that the preparer knew or reasonably should have known of the position. An income tax return preparer who prepares a return and engages in specified willful or reckless conduct with respect to preparing such a return is liable for a penalty of $1,000.

REASONS FOR CHANGE

The Committee believes that the standards of conduct applicable to income tax return preparers should be the same as the stand-ards applicable to taxpayers. Accordingly, the minimum standard for each undisclosed position on a tax return would be that the pre-parer must reasonably believe that the tax treatment is more likely than not the proper tax treatment. The Committee believes that



166 31 U.S.C. 5314. 167 31 U.S.C. 5321(a)(5).

this standard is appropriate because the tax return is signed under penalties of perjury, which implies a high standard of diligence in determining the facts and substantial accuracy in determining and applying the rules that govern those facts. The Committee believes that it is both appropriate and vital to the tax system that both taxpayers and their return preparers file tax returns that they rea-sonably believe are more likely than not correct. In addition, con-forming the standards of conduct applicable to income tax return preparers to the standards applicable to taxpayers will simplify the law by reducing confusion inherent in different standards applying to the same behavior.


The bill alters the standards of conduct that must be met to avoid imposition of the first penalty. The bill replaces the realistic possibility standard with a requirement that there be a reasonable belief that the tax treatment of the position was more likely than not the proper treatment. The bill also replaces the not frivolous standard with the requirement that there be a reasonable basis for the tax treatment of the position.

In addition, the bill increases the amount of these penalties. The penalty relating to not having a reasonable belief that the tax treatment was more likely than not the proper tax treatment is in-creased from $250 to $1,000. The penalty relating to willful or reck-less conduct is increased from $1,000 to $5,000.

EFFECTIVE DATE

The provision is effective for documents prepared after the date of enactment.

9. Penalty on failure to report interests in foreign financial ac-counts (sec. 622 of the bill and sec. 5321 of Title 31, United States Code)

PRESENT LAW

The Secretary of the Treasury must require citizens, residents, or persons doing business in the United States to keep records and file reports when that person makes a transaction or maintains an account with a foreign financial entity.166 In general, individuals must fulfill this requirement by answering questions regarding for-eign accounts or foreign trusts that are contained in Part III of Schedule B of the IRS Form 1040. Taxpayers who answer ‘‘yes’’ in response to the question regarding foreign accounts must then file Treasury Department Form TD F 90–22.1. This form must be filed with the Department of the Treasury, and not as part of the tax return that is filed with the IRS.

The Secretary of the Treasury may impose a civil penalty on any person who willfully violates this reporting requirement. The civil penalty is the amount of the transaction or the value of the ac-count, up to a maximum of $100,000; the minimum amount of the penalty is $25,000.167 In addition, any person who willfully violates this reporting requirement is subject to a criminal penalty. The


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168 31 U.S.C. 5322. 169 A Report to Congress in Accordance with Sec. 361(b) of the Uniting and Strengthening

America by Providing Appropriate Tools Required to itercept and Obstruct Terrorism Act of 2001, April 26, 2002.

170 Sec. 361(b) of the USA PATRIOT Act of 2001 (Pub. L. 107–56). 171 Because in general the Tax Court is the only pre-payment forum available to taxpayers,

it deals with most of the frivolous, groundless, or dilatory arguments raised in tax cases.

criminal penalty is a fine of not more than $250,000 or imprison-ment for not more than five years (or both); if the violation is part of a pattern of illegal activity, the maximum amount of the fine is increased to $500,000 and the maximum length of imprisonment is increased to 10 years.168

On April 26, 2002, the Secretary of the Treasury submitted to the Congress a report on these reporting requirements.169 This re-port, which was statutorily required,170 studies methods for im-proving compliance with these reporting requirements. It makes several administrative recommendations, but no legislative rec-ommendations. A further report is required to be submitted by the Secretary of the Treasury to the Congress by October 26, 2002.

REASONS FOR CHANGE

The Committee understands that the number of individuals in-volved in using offshore bank accounts to engage in abusive tax scams has grown significantly in recent years. For one scheme alone, the IRS estimates that there may be one to two million tax-payers with offshore bank accounts attempting to conceal income from the IRS. The Committee is concerned about this activity and believes that improving compliance with this reporting requirement is vitally important to sound tax administration, to combating ter-rorism, and to preventing the use of abusive tax schemes and scams. Adding a new civil penalty that applies without regard to willfulness will improve compliance with this reporting require-ment.


The bill adds an additional civil penalty that may be imposed on any person who violates this reporting requirement (without regard to willfulness). This new civil penalty is up to $5,000. The penalty may be waived if any income from the account was properly re-ported on the income tax return and there was reasonable cause for the failure to report.

EFFECTIVE DATE

The provision is effective with respect to failures to report occur-ring on or after the date of enactment.

10. Frivolous tax returns and submissions (sec. 623 of the bill and sec. 6702 of the Code)

PRESENT LAW

The Code provides that an individual who files a frivolous income tax return is subject to a penalty of $500 imposed by the IRS (sec. 6702). The Code also permits the Tax Court 171 to impose a penalty of up to $25,000 if a taxpayer has instituted or maintained pro-



172 31 U.S.C. 330.

ceedings primarily for delay or if the taxpayer’s position in the pro-ceeding is frivolous or groundless (sec. 6673(a)).

REASONS FOR CHANGE

The IRS has been faced with a significant number of tax filers who are filing returns based on frivolous arguments or who are seeking to hinder tax administration by filing returns that are pat-ently incorrect. In addition, taxpayers are using existing proce-dures for collection due process hearings, offers-in-compromise, in-stallment agreements, and taxpayer assistance orders to impede or delay tax administration by raising frivolous arguments. These pro-cedures were intended to provide assistance to taxpayers genuinely seeking to resolve legitimate disputes with the IRS, and the use of these procedures for impeding or delaying tax administration di-verts scarce IRS resources away from resolving genuine disputes. Allowing the IRS to assert more substantial penalties for frivolous submissions and to dismiss frivolous requests without the need to follow otherwise mandated procedures will deter frivolous taxpayer behavior and enable the IRS to use its resources to better assist taxpayers in resolving genuine disputes.


The bill modifies the IRS-imposed penalty by increasing the amount of the penalty to up to $5,000 and by applying it to all tax-payers and to all types of Federal taxes.

The provision also modifies present law with respect to certain submissions that raise frivolous arguments or that are intended to delay or impede tax administration. The submissions to which this provision applies are requests for a collection due process hearing, installment agreements, offers-in-compromise, and taxpayer assist-ance orders. First, the provision permits the IRS to dismiss such requests. Second, the provision permits the IRS to impose a penalty of up to $5,000 for such requests, unless the taxpayer withdraws the request after being given an opportunity to do so.

The provision requires the IRS to publish a list of positions, ar-guments, requests, and proposals determined to be frivolous for purposes of these provisions.

EFFECTIVE DATE

The provision is effective for submissions made and issues raised after the date on which the Secretary first prescribes the required list.

11. Regulation of individuals practicing before the Department of the Treasury (sec. 624 of the bill and sec. 330 of Title 31, United States Code)

PRESENT LAW

The Secretary of the Treasury is authorized to regulate the prac-tice of representatives of persons before the Department of the Treasury.172 The Secretary is also authorized to suspend or disbar from practice before the Department a representative who is incom-petent, who is disreputable, who violates the rules regulating prac-


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173 Sec. 6700.

tice before the Department, or who (with intent to defraud) will-fully and knowingly misleads or threatens the person being rep-resented (or a person who may be represented). The rules promul-gated by the Secretary pursuant to this provision are contained in Circular 230.

REASONS FOR CHANGE

The Committee believes that it is critical that the Secretary have the authority to censure tax advisors as well as to impose monetary sanctions against tax advisors because of the important role of tax advisors in our tax system. Use of these sanctions is expected to curb the participation of tax advisors in both tax shelter activity and any other activity that is contrary to Circular 230 standards.


The bill makes two modifications to expand the sanctions that the Secretary may impose pursuant to these statutory provisions. First, the bill expressly permits censure as a sanction.

Second, the bill permits the imposition of a monetary penalty as a sanction. If the representative is acting on behalf of an employer or other entity, the Secretary may impose a monetary penalty on the employer or other entity if it knew, or reasonably should have known, of the conduct. This monetary penalty on the employer or other entity may be imposed in addition to any monetary penalty imposed directly on the representative. These monetary penalties are not to exceed the gross income derived (or to be derived) from the conduct giving rise to the penalty. These monetary penalties may be in addition to, or in lieu of, any suspension, disbarment, or censure.

The bill also confirms the present-law authority of the Secretary to impose standards applicable to written advice with respect to an entity, plan, or arrangement that is of a type that the Secretary de-termines as having a potential for tax avoidance or evasion.

EFFECTIVE DATE

The modifications to expand the sanctions that the Secretary may impose are effective for actions taken after the date of enact-ment.

12. Penalties on promoters of tax shelters (sec. 625 of the bill and sec. 6700 of the Code)

PRESENT LAW

A penalty is imposed on any person who organizes, assists in the organization of, or participates in the sale of any interest in, a partnership or other entity, any investment plan or arrangement, or any other plan or arrangement, if in connection with such activ-ity the person makes or furnishes a qualifying false or fraudulent statement or a gross valuation overstatement.173 A qualified false or fraudulent statement is any statement with respect to the allow-ability of any deduction or credit, the excludability of any income, or the securing of any other tax benefit by reason of holding an in-terest in the entity or participating in the plan or arrangement



174 Sec. 1501.

which the person knows or has reason to know is false or fraudu-lent as to any material matter. A ‘‘gross valuation overstatement’’ means any statement as to the value of any property or services if the stated value exceeds 200 percent of the correct valuation, and the value is directly related to the amount of any allowable income tax deduction or credit.

The amount of the penalty is $1,000 (or, if the person establishes that it is less, 100 percent of the gross income derived or to be de-rived by the person from such activity). A penalty attributable to a gross valuation misstatement can be waived on a showing that there was a reasonable basis for the valuation and it was made in good faith.

REASONS FOR CHANGE

The Committee believes that the present-law penalty rate is in-sufficient to deter the type of conduct that gives rise to the penalty.


The provision modifies the penalty amount to equal 50 percent of the gross income derived by the person from the activity for which the penalty is imposed. The new penalty rate applies to any activity that involves a statement regarding the tax benefits of par-ticipating in a plan or arrangement if the person knows or has rea-son to know that such statement is false or fraudulent as to any material matter. The enhanced penalty does not apply to a gross valuation overstatement.

EFFECTIVE DATE

The provision is effective for activities after the date of enact-ment.

13. Affirmation of consolidated return regulation authority (sec. 631 of the bill and sec. 1502 of the Code)

PRESENT LAW

An affiliated group of corporations may elect to file a consoli-dated return in lieu of separate returns. A condition of electing to file a consolidated return is that all corporations that are members of the consolidated group must consent to all the consolidated re-turn regulations prescribed under section 1502 prior to the last day prescribed by law for filing such return.174

Section 1502 states:The Secretary shall prescribe such regulations as he

may deem necessary in order that the tax liability of any affiliated group of corporations making a consolidated re-turn and of each corporation in the group, both during and after the period of affiliation, may be returned, deter-mined, computed, assessed, collected, and adjusted, in such manner as clearly to reflect the income-tax liability and the various factors necessary for the determination of such


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175 Sec. 1502.176 Regulations issued under the authority of section 1502 are considered to be ‘‘legislative’’

regulations rather than ‘‘interpretative’’ regulations, and as such are usually given greater def-erence by courts in case of a taxpayer challenge to such a regulation. See, S. Rep. No. 960, 70th Cong., 1st Sess. at 15, describing the consolidated return regulations as ‘‘legislative in char-acter’’. The Supreme Court has stated that ‘‘. . . legislative regulations are given controlling weight unless they are arbitrary, capricious, or manifestly contrary to the statute.’’ Chevron, U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837, 844 (1984) (involving an environmental protection regulation). For examples involving consolidated return regulations, see, e.g., Wolter Construction Company v. Commissioner, 634 F.2d 1029 (6th Cir. 1980); Garvey, Inc. v. United States, 1 Ct. Cl. 108 (1983), aff’d 726 F.2d 1569 (Fed. Cir. 1984), cert. denied 469 U.S. 823 (1984). Compare, e.g., Audrey J. Walton v. Commissioner, 115 T.C. 589 (2000), describing different standards of review. The case did not involve a consolidated return regula-tion.

177 255 F.3d 1357 (Fed. Cir. 2001), reh’g denied, 2001 U.S. App. LEXIS 23207 (Fed. Cir. Oct. 3, 2001).

178 Prior to this decision, there had been a few instances involving prior laws in which certain consolidated return regulations were held to be invalid. See, e.g., American Standard, Inc. v. United States, 602 F.2d 256 (Ct. Cl. 1979), discussed in the text infra. see also Union Carbide Corp. v. United States, 612 F.2d 558 (Ct. Cl. 1979), and Allied Corporation v. United States, 685 F. 2d 396 (Ct. Cl. 1982), all three cases involving the allocation of income and loss within a consolidated group for purposes of computation of a deduction allowed under prior law by the Code for Western Hemisphere Trading Corporations. . See also Joseph Weidenhoff v. Commis-sioner, 32 T.C. 1222, 1242–1244 (1959), involving the application of certain regulations to the excess profits tax credit allowed under prior law, and concluding that the Commissioner had applied a particular regulation in an arbitrary manner inconsistent with the wording of the reg-ulation and inconsistent with even a consolidated group computation. Cf. Kanawha Gas & Utili-ties Co. v. Commissioner, 214 F.2d 685 (1954), concluding that the substance of a transaction was an acquisition of assets rather than stock. Thus, a regulation governing basis of the assets of consolidated subsidiaries did not apply to the case. See also General Machinery Corporation v. Commissioner, 33 B.T.A. 1215 (1936); Lefcourt Realty Corporation, 31 B.T.A. 978 (1935); Helvering v. Morgans, Inc., 293 U.S. 121 (1934), interpreting the term ‘‘taxable year.’’

179 Treas. Reg. Sec. 1.1502–20(c)(1)(iii). 180 Treasury Regulation section 1.1502–20, generally imposing certain ‘‘loss disallowance’’

rules on the disposition of subsidiary stock, contained other limitations besides the ‘‘duplicated loss’’ rule that could limit the loss available to the group on a disposition of a subsidiary’s stock. Treasury Regulation section 1.1502–20 as a whole was promulgated in connection with regula-tions issued under section 337(d), principally in connection with the so-called General Utilities repeal of 1986 (referring to the case of General Utilities & Operating Company v. Helvering, 296 U.S. 200 (1935)). Such repeal generally required a liquidating corporation, or a corporation acquired in a stock acquisition treated as a sale of assets, to pay corporate level tax on the ex-cess of the value of its assets over the basis. Treasury regulation section 1.1502–20 principally reflected an attempt to prevent corporations filing consolidated returns from offsetting income with a loss on the sale of subsidiary stock. Such a loss could result from the unique upward adjustment of a subsidiary’s stock basis required under the consolidated return regulations for subsidiary income earned in consolidation, an adjustment intended to prevent taxation of both the subsidiary and the parent on the same income or gain. As one example, absent a denial of certain losses on a sale of subsidiary stock, a consolidated group could obtain a loss deduction with respect to subsidiary stock, the basis of which originally reflected the subsidiary’s value at the time of the purchase of the stock, and that had then been adjusted upward on recognition of any built-in income or gain of the subsidiary reflected in that value. The regulations also con-tained the duplicated loss factor addressed by the court in Rite Aid. The preamble to the regula-tions stated: ‘‘it is not administratively feasible to differentiate between loss attributable to built-in gain and duplicated loss.’’ T.D. 8364, 1991–2 C.B. 43, 46 (Sept. 13, 1991). The govern-ment also argued in the Rite Aid case that duplicated loss was a separate concern of the regula-tions. 255 F.3d at 1360.

liability, and in order to prevent the avoidance of such tax liability.175

Under this authority, the Treasury Department has issued exten-sive consolidated return regulations.176

In the recent case of Rite Aid Corp. v. United States,177 the Fed-eral Circuit Court of Appeals addressed the application of a par-ticular provision of certain consolidated return loss disallowance regulations, and concluded that the provision was invalid.178 The particular provision, known as the ‘‘duplicated loss’’ provision,179 would have denied a loss on the sale of stock of a subsidiary by a parent corporation that had filed a consolidated return with the subsidiary, to the extent the subsidiary corporation had assets that had a built-in loss, or had a net operating loss, that could be recog-nized or used later.180



181 For example, the court stated: ‘‘The duplicated loss factor . . . addresses a situation that arises from the sale of stock regardless of whether corporations file separate or consolidated re-turns. With I.R.C. secs. 382 and 383, Congress has addressed this situation by limiting the sub-sidiary’s potential future deduction, not the parent’s loss on the sale of stock under I.R.C. sec. 165.’’ 255 F.3d 1357, 1360 (Fed. Cir. 2001).

182 S. Rep. No. 960, 70th Cong., 1st Sess. 15 (1928). Though not quoted by the court in Rite Aid, the same Senate report also indicated that one purpose of the consolidated return authority was to permit treatment of the separate corporations as if they were a single unit, stating ‘‘The mere fact that by legal fiction several corporations owned by the same shareholders are separate entities should not obscure the fact that they are in reality one and the same business owned by the same individuals and operated as a unit.’’ S. Rep. No. 960, 70th Cong., 1st Sess. 29 (1928).

183 American Standard, Inc. v. United States, 602 F.2d 256, 261 (Ct. Cl. 1979). That case did not involve the question of separate returns as compared to a single return approach. It involved the computation of a Western Hemisphere Trade Corporation (‘‘WHTC’’) deduction under prior law (which deduction would have been computed as a percentage of each WHTC’s taxable in-come if the corporations had filed separate returns), in a case where a consolidated group in-cluded several WHTCs as well as other corporations. The question was how to apportion income and losses of the admittedly consolidated WHTCs and how to combine that computation with the rest of the group’s consolidated income or losses. The court noted that the new, changed regulations approach varied from the approach taken to a similar problem involving public utili-ties within a group and previously allowed for WHTCs. The court objected that the allocation method adopted by the regulation allowed non-WHTC losses to reduce WHTC income. However, the court did not disallow a method that would net WHTC income of one WHTC with losses of another WHTC, a result that would not have occurred under separate returns. Nor did the court expressly disallow a different fractional method that would net both income and losses of the WHTCs with those of other corporations in the consolidated group. The court also found that the regulation had been adopted without proper notice.

The Federal Circuit Court opinion contained language discussing the fact that the regulation produced a result different than the re-sult that would have obtained if the corporations had filed separate returns rather than consolidated returns.181

The Federal Circuit Court opinion cited a 1928 Senate Finance Committee Report to legislation that authorized consolidated re-turn regulations, which stated that ‘‘many difficult and complicated problems, * * * have arisen in the administration of the provisions permitting the filing of consolidated returns’’ and that the com-mittee ‘‘found it necessary to delegate power to the commissioner to prescribe regulations legislative in character covering them.’’ 182 The Court’s opinion also cited a previous decision of the Court of Claims for the proposition, interpreting this legislative history, that section 1502 grants the Secretary ‘‘the power to conform the appli-cable income tax law of the Code to the special, myriad problems resulting from the filing of consolidated income tax returns;’’ but that section 1502 ‘‘does not authorize the Secretary to choose a method that imposes a tax on income that would not otherwise be taxed.’’ 183

The Federal Circuit Court construed these authorities and ap-plied them to invalidate Treas. Reg. Sec. 1.1502–20(c)(1)(iii), stat-ing that:

The loss realized on the sale of a former subsidiary’s as-sets after the consolidated group sells the subsidiary’s stock is not a problem resulting from the filing of consoli-dated income tax returns. The scenario also arises where a corporate shareholder sells the stock of a non-consoli-dated subsidiary. The corporate shareholder could realize a loss under I.R.C. sec. 1001, and deduct the loss under I.R.C. sec. 165. The subsidiary could then deduct any losses from a later sale of assets. The duplicated loss fac-tor, therefore, addresses a situation that arises from the sale of stock regardless of whether corporations file sepa-rate or consolidated returns. With I.R.C. secs. 382 and 383,


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184 Rite Aid, 255 F.3d at 1360.185 See Temp. Reg. 1.1502–20T(i)(2). The Treasury Department has also indicated its intention

to continue to study all the issues that the original loss disallowance regulations addressed (in-cluding issues of furthering single entity principles) and possibly issue different regulations (not including the particular approach of Treas. Reg. Sec. 1.1502–20(c)(1)(iii)) on the issues in the future. See Notice 2002–11, 2002–7 I.R.B. 526 (Feb. 19, 2002); T.D. 8984, 67 F.R. 11034 (March 12, 2002); REG–102740–02, 67 F.R. 11070 (March 12, 2002); see also Notice 2002–18, 2002–12 I.R.B. 644 (March 25, 2002).

Congress has addressed this situation by limiting the sub-sidiary’s potential future deduction, not the parent’s loss on the sale of stock under I.R.C. sec. 165.184

The Treasury Department has announced that it will not con-tinue to litigate the validity of the duplicated loss provision of the regulations, and has issued interim regulations that permit tax-payers for all years to elect a different treatment, though they may apply the provision for the past if they wish.185

REASONS FOR CHANGE

The Committee is concerned that the language and analysis in the Rite Aid decision might lead taxpayers to attempt to challenge other Treasury consolidated return regulations that prescribe a tax result different from the result that would occur if separate returns were filed.

The Committee is concerned that any such challenges may lead to protracted litigation and commitment of Internal Revenue Serv-ice resources to defending the consolidated return provisions.

The Committee wishes to clarify that the fact that a result under the consolidated return regulations differs from the result under separate returns does not provide a basis to challenge a Treasury consolidated return regulation.

The Committee believes that the result of the case with respect to the type of factual situation in Rite Aid, involving the ‘‘dupli-cated loss factor’’ portion of Treasury Regulation section 1.1502–20, which Treasury has announced that taxpayers need not follow, should not be overturned. Therefore, the committee legislatively al-lows the specific result of the case to stand for the taxpayer in Rite Aid or any similarly situated taxpayers.

Apart from that specific result, the Committee disagrees with the reasoning of the case and believes it should not be applied to sup-port any challenge to other consolidated return regulations. The Committee also wishes to reaffirm the broad authority of the Treasury Department to issue consolidated return regulations.


The provision confirms that, in exercising its authority under section 1502 to issue consolidated return regulations, the Treasury Department may provide rules treating corporations filing consoli-dated returns differently from corporations filing separate returns.

Thus, under the statutory authority of section 1502, the Treasury Department is authorized to issue consolidated return regulations utilizing either a single taxpayer or separate taxpayer approach or a combination of the two approaches, as Treasury deems necessary in order that the tax liability of any affiliated group of corporations making a consolidated return, and of each corporation in the group, both during and after the period of affiliation, may be determined



186 Treas. Reg. Sec. 1.1502–20(c)(1)(iii). 187 The Committee does not intend to overrule the current Treasury Department regulations,

which allow taxpayers for the past to follow Treasury Regulations Section 1.1502–20(c)(1)(iii), if they choose to do so. Temp. Reg. Sec. 1.1502–20T(i)(2).

188 See, e.g., Notice 2002–11, 2002–7 I.R.B. 526 (Feb. 19, 2002); T.D. 8984, 67 F.R. 11034 (Mar.12, 2002); REG–102740–02, 67 F.R. 11070 (Mar.12, 2002); see also Notice 2002–18, 2002–12 I.R.B. 644 (Mar. 25, 2002). In exercising its authority under section 1502, the Secretary is also authorized to prescribe rules that protect the purpose of General Utilities repeal using pre-sumptions and other simplifying conventions.

and adjusted in such manner as clearly to reflect the income-tax liability and the various factors necessary for the determination of such liability, and in order to prevent avoidance of such liability.

Rite Aid is thus overruled to the extent it suggests that there is not a problem that can be addressed in consolidated return regula-tions if application of a particular Code provision on a separate tax-payer basis would produce a result different from single taxpayer principles that may be used for consolidation.

The provision nevertheless allows the result of the Rite Aid case to stand with respect to the type of factual situation presented in the case. That is, the legislation provides for the override of the regulatory provision that took the approach of denying a loss on a deconsolidating disposition of stock of a consolidated subsidiary 186 to the extent the subsidiary had net operating losses or built in losses that could be used later outside the group.187

Retaining the result in the Rite Aid case with respect to the par-ticular regulation section 1.1502–20(c)(1)(iii) as applied to the fac-tual situation of the case does not in any way prevent or invalidate the various approaches Treasury has announced it will apply or that it intends to consider in lieu of the approach of that regula-tion, including, for example, the denial of a loss on a stock sale if inside losses of a subsidiary may also be used by the consolidated group, and the possible requirement that inside attributes be ad-justed when a subsidiary leaves a group.188

EFFECTIVE DATE

The provision is effective for all years, whether beginning before, on, or after the date of enactment of the provision.

No inference is intended that the results following from this pro-vision are not the same as the results under present law.

B. TAX TREATMENT OF INVERSION TRANSACTIONS

(Sec. 641 of the bill and new sec. 7874 of the Code)

PRESENT LAW

Determination of corporate residence The U.S. tax treatment of a multinational corporate group de-

pends significantly on whether the top-tier ‘‘parent’’ corporation of the group is domestic or foreign. For purposes of U.S. tax law, a corporation is treated as domestic if it is incorporated under the law of the United States or of any State. All other corporations (i.e., those incorporated under the laws of foreign countries) are treated as foreign. Thus, place of incorporation determines whether a corporation is treated as domestic or foreign for purposes of U.S. tax law, irrespective of other factors that might be thought to bear on a corporation’s ‘‘nationality,’’ such as the location of the corpora-


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tion’s management activities, employees, business assets, oper-ations, or revenue sources, the exchanges on which the corpora-tion’s stock is traded, or the residence of the corporation’s man-agers and shareholders.

U.S. taxation of domestic corporations The United States employs a ‘‘worldwide’’ tax system, under

which domestic corporations generally are taxed on all income, whether derived in the United States or abroad. In order to miti-gate the double taxation that may arise from taxing the foreign-source income of a domestic corporation, a foreign tax credit for in-come taxes paid to foreign countries is provided to reduce or elimi-nate the U.S. tax owed on such income, subject to certain limita-tions.

Income earned by a domestic parent corporation from foreign op-erations conducted by foreign corporate subsidiaries generally is subject to U.S. tax when the income is distributed as a dividend to the domestic corporation. Until such repatriation, the U.S. tax on such income is generally deferred. However, certain anti-defer-ral regimes may cause the domestic parent corporation to be taxed on a current basis in the United States with respect to certain cat-egories of passive or highly mobile income earned by its foreign subsidiaries, regardless of whether the income has been distributed as a dividend to the domestic parent corporation. The main anti- deferral regimes in this context are the controlled foreign corpora-tion rules of subpart F (sections 951–964) and the passive foreign investment company rules (sections 1291–1298). A foreign tax cred-it is generally available to offset, in whole or in part, the U.S. tax owed on this foreign-source income, whether repatriated as an ac-tual dividend or included under one of the anti-deferral regimes.

U.S. taxation of foreign corporations The United States taxes foreign corporations only on income that

has a sufficient nexus to the United States. Thus, a foreign cor-poration is generally subject to U.S. tax only on income that is ‘‘ef-fectively connected’’ with the conduct of a trade or business in the United States. Such ‘‘effectively connected income’’ generally is taxed in the same manner and at the same rates as the income of a U.S. corporation. An applicable tax treaty may limit the imposi-tion of U.S. tax on business operations of a foreign corporation to cases in which the business is conducted through a ‘‘permanent es-tablishment’’ in the United States.

In addition, foreign corporations generally are subject to a gross-basis U.S. tax at a flat 30–percent rate on the receipt of interest, dividends, rents, royalties, and certain similar types of income de-rived from U.S. sources, subject to certain exceptions. The tax gen-erally is collected by means of withholding by the person making the payment. This tax may be reduced or eliminated under an ap-plicable tax treaty.

U.S. tax treatment of inversion transactions Under present law, U.S. corporations may reincorporate in for-

eign jurisdictions and thereby replace the U.S. parent corporation of a multinational corporate group with a foreign parent corpora-tion. These transactions are commonly referred to as ‘‘inversion’’



transactions. Inversion transactions may take many different forms, including stock inversions, asset inversions, and various combinations of and variations on the two. Most of the known transactions to date have been stock inversions. In one example of a stock inversion, a U.S. corporation forms a foreign corporation, which in turn forms a domestic merger subsidiary. The domestic merger subsidiary then merges into the U.S. corporation, with the U.S. corporation surviving, now as a subsidiary of the new foreign corporation. The U.S. corporation’s shareholders receive shares of the foreign corporation and are treated as having exchanged their U.S. corporation shares for the foreign corporation shares. An asset inversion reaches a similar result, but through a direct merger of the top-tier U.S. corporation into a new foreign corporation, among other possible forms. An inversion transaction may be accompanied or followed by further restructuring of the corporate group. For ex-ample, in the case of a stock inversion, in order to remove income from foreign operations from the U.S. taxing jurisdiction, the U.S. corporation may transfer some or all of its foreign subsidiaries di-rectly to the new foreign parent corporation or other related foreign corporations.

In addition to removing foreign operations from the U.S. taxing jurisdiction, the corporate group may derive further advantage from the inverted structure by reducing U.S. tax on U.S.-source in-come through various ‘‘earnings stripping’’ or other transactions. This may include earnings stripping through payment by a U.S. corporation of deductible amounts such as interest, royalties, rents, or management service fees to the new foreign parent or other for-eign affiliates. In this respect, the post-inversion structure enables the group to employ the same tax-reduction strategies that are available to other multinational corporate groups with foreign par-ents and U.S. subsidiaries, subject to the same limitations. These limitations under present law include section 163(j), which limits the deductibility of certain interest paid to related parties, if the payor’s debt-equity ratio exceeds 1.5 to 1 and the payor’s net inter-est expense exceeds 50 percent of its ‘‘adjusted taxable income.’’ More generally, section 482 and the regulations thereunder require that all transactions between related parties be conducted on terms consistent with an ‘‘arm’s length’’ standard, and permit the Sec-retary of the Treasury to reallocate income and deductions among such parties if that standard is not met.

Inversion transactions may give rise to immediate U.S. tax con-sequences at the shareholder and/or the corporate level, depending on the type of inversion. In stock inversions, the U.S. shareholders generally recognize gain (but not loss) under section 367(a), based on the difference between the fair market value of the foreign cor-poration shares received and the adjusted basis of the domestic cor-poration stock exchanged. To the extent that a corporation’s share value has declined, and/or it has many foreign or tax-exempt share-holders, the impact of this section 367(a) ‘‘toll charge’’ is reduced. The transfer of foreign subsidiaries or other assets to the foreign parent corporation also may give rise to U.S. tax consequences at the corporate level (e.g., gain recognition and earnings and profits inclusions under sections 1001, 311(b), 304, 367, 1248 or other pro-visions). The tax on any income recognized as a result of these


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restructurings may be reduced or eliminated through the use of net operating losses, foreign tax credits, and other tax attributes.

In asset inversions, the U.S. corporation generally recognizes gain (but not loss) under section 367(a) as though it had sold all of its assets, but the shareholders generally do not recognize gain or loss, assuming the transaction meets the requirements of a reor-ganization under section 368.

REASONS FOR CHANGE

The Committee believes that inversion transactions resulting in a minimal presence in a foreign country of incorporation are a means of avoiding U.S. tax and should be curtailed. In particular, these transactions permit corporations and other entities to con-tinue to conduct business in the same manner as they did prior to the inversion, but with the result that the inverted entity avoids U.S. tax on foreign operations and may engage in earnings-strip-ping techniques to avoid U.S. tax on domestic operations. The Com-mittee believes that certain inversion transactions (involving 80 percent or more identity of stock ownership) have little or no non-tax effect or purpose and should be disregarded for U.S. tax pur-poses. The Committee believes that other inversion transactions (involving more than 50 but less than 80 percent identity of stock ownership) may have sufficient non-tax effect and purpose to be re-spected, but warrant heightened scrutiny and other restrictions to ensure that the U.S. tax base is not eroded through related-party transactions.


In general The provision defines two different types of corporate inversion

transactions and establishes a different set of consequences for each type. Certain partnership transactions also are covered.

Transactions involving at least 80 percent identity of stock owner-ship

The first type of inversion is a transaction in which, pursuant to a plan or a series of related transactions: (1) a U.S. corporation be-comes a subsidiary of a foreign-incorporated entity or otherwise transfers substantially all of its properties to such an entity; (2) the former shareholders of the U.S. corporation hold (by reason of hold-ing stock in the U.S. corporation) 80 percent or more (by vote or value) of the stock of the foreign-incorporated entity after the transaction; and (3) the foreign-incorporated entity, considered to-gether with all companies connected to it by a chain of greater than 50 percent ownership (i.e., the ‘‘expanded affiliated group’’), does not have substantial business activities in the entity’s country of incorporation, compared to the total worldwide business activities of the expanded affiliated group. The provision denies the intended tax benefits of this type of inversion by deeming the top-tier foreign



189 Since the top-tier foreign corporation would be treated for all purposes of the Code as do-mestic, the shareholder-level ‘‘toll charge’’ of sec. 367(a) would not apply to these inversion transactions.

corporation to be a domestic corporation for all purposes of the Code.189

In determining whether a transaction would meet the definition of an inversion under the provision, stock held by members of the expanded affiliated group that includes the foreign incorporated en-tity is disregarded. For example, if the former top-tier U.S. corpora-tion receives stock of the foreign incorporated entity (e.g., so-called ‘‘hook’’ stock), the stock would not be considered in determining whether the transaction meets the definition. Similarly, if a U.S. parent corporation converts an existing wholly owned U.S. sub-sidiary into a new wholly owned controlled foreign corporation, the stock of the new foreign corporation would be disregarded. Stock sold in a public offering related to the transaction also is dis-regarded for these purposes.

Transfers of properties or liabilities as part of a plan a principal purpose of which is to avoid the purposes of the provision are dis-regarded. In addition, the Treasury Secretary is granted authority to prevent the avoidance of the purposes of the provision, including avoidance through the use of related persons, pass-through or other noncorporate entities, or other intermediaries, and through trans-actions designed to qualify or disqualify a person as a related per-son or a member of an expanded affiliated group. Similarly, the Treasury Secretary is granted authority to treat certain non-stock instruments as stock, and certain stock as not stock, where nec-essary to carry out the purposes of the provision.

Transactions involving greater than 50 percent but less than 80 per-cent identity of stock ownership

The second type of inversion is a transaction that would meet the definition of an inversion transaction described above, except that the 80-percent ownership threshold is not met. In such a case, if a greater-than-50-percent ownership threshold is met, then a sec-ond set of rules applies to the inversion. Under these rules, the in-version transaction is respected (i.e., the foreign corporation is treated as foreign), but: (1) any applicable corporate-level ‘‘toll charges’’ for establishing the inverted structure may not be offset by tax attributes such as net operating losses or foreign tax credits; (2) the IRS is given expanded authority to monitor related-party transactions that may be used to reduce U.S. tax on U.S.-source in-come going forward; and (3) section 163(j), relating to ‘‘earnings stripping’’ through related-party debt, is strengthened. These meas-ures generally apply for a 10–year period following the inversion transaction. In addition, inverting entities are required to provide information to shareholders or partners and the IRS with respect to the inversion transaction.

With respect to ‘‘toll charges,’’ any applicable corporate-level in-come or gain required to be recognized under sections 304, 311(b), 367, 1001, 1248, or any other provision with respect to the transfer of controlled foreign corporation stock or other assets by a U.S. cor-poration as part of the inversion transaction or after such trans-action to a related foreign person is taxable, without offset by any tax attributes (e.g., net operating losses or foreign tax credits). To


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the extent provided in regulations, this rule will not apply to cer-tain transfers of inventory and similar transactions conducted in the ordinary course of the taxpayer’s business.

In order to enhance IRS monitoring of related-party transactions, the provision establishes a new pre-filing procedure. Under this procedure, the taxpayer will be required annually to submit an ap-plication to the IRS for an agreement that all return positions to be taken by the taxpayer with respect to related-party transactions comply with all relevant provisions of the Code, including sections 163(j), 267(a)(3), 482, and 845. The Treasury Secretary is given the authority to specify the form, content, and supporting information required for this application, as well as the timing for its submis-sion.

The IRS will be required to take one of the following three ac-tions within 90 days of receiving a complete application from a tax-payer: (1) conclude an agreement with the taxpayer that the return positions to be taken with respect to related-party transactions comply with all relevant provisions of the Code; (2) advise the tax-payer that the IRS is satisfied that the application was made in good faith and substantially complies with the requirements set forth by the Treasury Secretary for such an application, but that the IRS reserves substantive judgment as to the tax treatment of the relevant transactions pending the normal audit process; or (3) advise the taxpayer that the IRS has concluded that the applica-tion was not made in good faith or does not substantially comply with the requirements set forth by the Treasury Secretary.

In the case of a compliance failure described in (3) above (and in cases in which the taxpayer fails to submit an application), the fol-lowing sanctions will apply for the taxable year for which the appli-cation was required: (1) no deductions or additions to basis or cost of goods sold for payments to foreign related parties will be per-mitted; (2) any transfers or licenses of intangible property to re-lated foreign parties will be disregarded; and (3) any cost-sharing arrangements will not be respected.

If the IRS fails to act on the taxpayer’s application within 90 days of receipt, then the taxpayer will be treated as having sub-mitted in good faith an application that substantially complies with the above-referenced requirements. Thus, the deduction disallow-ance and other sanctions described above will not apply, but the IRS will be able to examine the transactions at issue under the normal audit process. The IRS is authorized to request that the taxpayer extend this 90-day deadline in cases in which the IRS be-lieves that such an extension might help the parties to reach an agreement.

The ‘‘earnings stripping’’ rules of section 163(j), which deny or defer deductions for certain interest paid to foreign related parties, are strengthened for inverted corporations. With respect to such corporations, the provision eliminates the debt-equity threshold generally applicable under section 163(j) and reduces the 50-per-cent thresholds for ‘‘excess interest expense’’ and ‘‘excess limita-tion’’ to 25 percent. In cases in which a U.S. corporate group ac-quires subsidiaries or other assets from an unrelated inverted cor-porate group, the provisions described above generally do not apply to the acquiring U.S. corporate group or its related parties (includ-ing the newly acquired subsidiaries or assets) by reason of acquir-



190 Sec. 845(a). 191 See S. Rep. No. 97–494, ‘‘Tax Equity and Fiscal Responsibility Act of 1982,’’ July 12, 1982,

337 (describing provisions relating to the repeal of modified coinsurance provisions).

ing the subsidiaries or assets that were connected with the inver-sion transaction. The Treasury Secretary is given authority to issue regulations appropriate to carry out the purposes of this provision and to prevent its abuse.

Partnership transactions Under the provision, both types of inversion transactions include

certain partnership transactions. Specifically, both parts of the pro-vision apply to transactions in which a foreign-incorporated entity acquires substantially all of the properties constituting a trade or business of a domestic partnership, if after the acquisition at least 80 percent (or more than 50 percent but less than 80 percent, as the case may be) of the stock of the entity is held by former part-ners of the partnership (by reason of holding their partnership in-terests), and the ‘‘substantial business activities’’ test is not met. For purposes of determining whether these tests are met, all part-nerships that are under common control within the meaning of sec-tion 482 are treated as one partnership, except as provided other-wise in regulations. In addition, the modified ‘‘toll charge’’ provi-sions apply at the partner level.

EFFECTIVE DATE

The regime applicable to transactions involving at least 80 per-cent identity of ownership applies to inversion transactions com-pleted after March 20, 2002. The rules for inversion transactions involving greater-than-50-percent identity of ownership apply to in-version transactions completed after 1996 that meet the 50-percent test and to inversion transactions completed after 1996 that would have met the 80-percent test but for the March 20, 2002 date.

C. REINSURANCE AGREEMENTS


PRESENT LAW

In the case of a reinsurance agreement between two or more re-lated persons, present law provides the Treasury Secretary with authority to allocate among the parties or recharacterize income (whether investment income, premium or otherwise), deductions, assets, reserves, credits and any other items related to the reinsur-ance agreement, or make any other adjustment, in order to reflect the proper source and character of the items for each party.190 For this purpose, related persons are defined as in section 482. Thus, persons are related if they are organizations, trades or businesses (whether or not incorporated, whether or not organized in the United States, and whether or not affiliated) that are owned or controlled directly or indirectly by the same interests. The provi-sion may apply to a contract even if one of the related parties is not a domestic company.191 In addition, the provision also permits such allocation, recharacterization, or other adjustments in a case in which one of the parties to a reinsurance agreement is, with re-spect to any contract covered by the agreement, in effect an agent


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192 The authority to allocate, recharacterize or make other adjustments was granted in connec-tion with the repeal of provisions relating to modified coinsurance transactions.

of another party to the agreement, or a conduit between related persons.

REASONS FOR CHANGE

The Committee is concerned that reinsurance transactions are being used to allocate income, deductions, or other items inappro-priately among U.S. and foreign related persons. The Committee is concerned that foreign related party reinsurance arrangements may be a technique for erosion of the U.S. tax base. The Committee believes that the provision of present law permitting the Treasury Secretary to allocate or recharacterize items related to a reinsur-ance agreement should be applied to prevent misallocation, im-proper characterization, or to make any other adjustment in the case of such reinsurance transactions between U.S. and foreign re-lated persons (or agents or conduits). The Committee also wishes to clarify that, in applying the authority with respect to reinsur-ance agreements, the amount, source or character of the items may be allocated, recharacterized or adjusted.


The provision clarifies the rules of section 845, relating to au-thority for the Treasury Secretary to allocate items among the par-ties to a reinsurance agreement, recharacterize items, or make any other adjustment, in order to reflect the proper source and char-acter of the items for each party. The provision authorizes such al-location, recharacterization, or other adjustment, in order to reflect the proper source, character or amount of the item. It is intended that this authority 192 be exercised in a manner similar to the au-thority under section 482 for the Treasury Secretary to make ad-justments between related parties. It is intended that this author-ity be applied in situations in which the related persons (or agents or conduits) are engaged in cross- border transactions that require allocation, recharacterization, or other adjustments in order to re-flect the proper source, character or amount of the item or items. No inference is intended that present law does not provide this au-thority with respect to reinsurance agreements.

The Committee notes that no regulations have been issued under section 845(a). The Committee expects that the Treasury Depart-ment shall issue regulations under section 845(a) to address effec-tively the allocation of income (whether investment income, pre-mium or otherwise) and other items, the recharacterization of such items, or any other adjustment necessary to reflect the proper amount, source or character of the item.

EFFECTIVE DATE

The provision is effective for any risk reinsured after April 11, 2002.



193 An Act to provide that members of the Armed Forces performing services for the peace-keeping efforts in Bosnia and Herzegovina, Croatia, and Macedonia shall be entitled to tax bene-fits in the same manner as if such services were performed in a combat zone, and for other pur-poses (March 20, 1996).

194 These user fees were originally enacted in section 10511 of the Revenue Act of 1987 (Public Law 100–203, December 22, 1987).

D. EXTENSION OF IRS USER FEES

(Sec. 661 of the bill and new sec. 7527 of the Code)

PRESENT LAW

The IRS provides written responses to questions of individuals, corporations, and organizations relating to their tax status or the effects of particular transactions for tax purposes. The IRS gen-erally charges a fee for requests for a letter ruling, determination letter, opinion letter, or other similar ruling or determination. Pub-lic Law 104–117 193 extended the statutory authorization for these user fees 194 through September 30, 2003.

REASONS FOR CHANGE

The Committee believes that it is appropriate to extend the stat-utory authorization for these user fees.


The bill extends the statutory authorization for these user fees through June 30, 2008. The bill also moves the statutory authoriza-tion for these fees into the Internal Revenue Code.

EFFECTIVE DATE

The provision, including moving the statutory authorization for these fees into the Code and repealing the off-Code statutory au-thorization for these fees, is effective for requests made after the date of enactment.

E. EXTENSION OF CUSTOMS SERVICE USER FEES


PRESENT LAW

Section 13031(j)(3) of the Consolidated Omnibus Budget Rec-onciliation Act of 1985 (19 U.S.C. 58c(j)(3)) authorizes the tem-porary imposition and collection of custom user fees in connection with services provided by the United States Customs Service. The authorization is scheduled to expire on September 30, 2003.

REASONS FOR CHANGE

The Committee believes that it is appropriate to extend the stat-utory authorization for these user fees.


The provision extends the authority to impose and collect custom user fees through June 30, 2008, provided, however, that any rev-enue generated from such custom user fees may be used only to fund the operations of the United States Customs Service.


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EFFECTIVE DATE


III. BUDGET EFFECTS OF THE BILL

A. COMMITTEE ESTIMATES

In compliance with paragraph 11(a) of rule XXVI of the Standing Rules of the Senate, the following statement is made concerning the estimated budget effects of the committee amendment to the bill as reported.



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B. BUDGET AUTHORITY AND TAX EXPENDITURES

Budget authority In compliance with section 308(a)(1) of the Budget Act, the Com-

mittee states that the revenue provisions of the committee amend-ment to the bill as reported involve new or increased budget au-thority.

Tax expenditures In compliance with section 308(a)(2) of the Budget Act, the Com-

mittee states that the revenue-reducing provisions of the committee amendment to the bill involve increased expenditures (see revenue table in Part III.A., above). The revenue increasing provisions of the Committee amendment to the bill involve reduced expenditures (see revenue table in Part III.A., above).

C. CONSULTATION WITH CONGRESSIONAL BUDGET OFFICE

In accordance with section 403 of the Budget Act, the Committee advises that the Congressional Budget Office has not submitted a statement on the committee amendment to the bill. The letter from the Congressional Budget Office was not received in a timely man-ner, and therefore will be provided separately.

IV. VOTES OF THE COMMITTEE

In compliance with paragraph 7(b) of rule XXVI of the Standing Rules of the Senate, the following statements are made concerning the votes taken on the Committee’s consideration of the amend-ment to the bill.

Motion to report the committee amendment The amendment to the bill was ordered favorably reported by a

voice vote, a quorum being present, on June 18, 2002.

Votes on other amendments An amendment by Senator Breaux to increase the percentage

limitations on certain scholarship grant programs of private foun-dations was agreed to by a voice vote.

An amendment by Senator Grassley to provide a tax credit for qualified financial institutions that have an individual development account program was agreed to by a voice vote.

An amendment by Senator Gramm to strike the provision exclud-ing 25 percent of the capital gain on sales of land or interests in land made for conservation purposes was not agreed to by a voice vote.

An amendment by Senator Baucus in a Chairman’s modification to the bill adding the provision regarding the affirmation of the consolidated return regulation authority was agreed to by voice vote.

V. REGULATORY IMPACT AND OTHER MATTERS

A. REGULATORY IMPACT

Pursuant to paragraph 11(b) of rule XXVI of the Standing Rules of the Senate, the Committee makes the following statement con-


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cerning the regulatory impact that might be incurred in carrying out the provisions of the bill as amended.

Impact on individuals and businesses With respect to the provisions that do not increase revenue, the

committee amendment to the bill modifies the rules relating to (1) certain charitable giving incentives; (2) disclosure of information relating to tax-exempt organizations; (3) tax treatment and proce-dures relating to exempt organizations; (4) restoration of funds for the Social Services Block Grant; and (5) individual development ac-counts. The Social Services Block Grant provisions provide in-creased funding to States to support a variety of social services. Under the other provisions listed above, taxpayers may elect whether to avail themselves of the provisions. Thus, the provisions do not impose increased regulatory burdens on individuals or busi-nesses.

With respect to the revenue-increasing provisions, the committee amendment to the bill modifies the rules relating to (1) the disclo-sure of reportable transactions and tax shelters; (2) the substantial understatement penalty; (3) actions to enjoin conduct with respect to tax shelters; (4) an understatement of a taxpayer’s liability by an income tax return preparer; (5) the imposition of a civil penalty (of up to $5,000) on a failure to report interest in foreign financial accounts; (6) frivolous tax submissions; and (7) inversion and cer-tain partnership transactions. These provisions relate to taxpayers that engage in certain tax avoidance transactions; taxpayers that have not undertaken or planned to undertake such transactions generally are not affected by the provisions of the bill. Thus, the revenue provisions generally do not impose increased regulatory burdens on individuals or businesses.

Impact on personal privacy and paperwork The provisions of the committee amendment to the bill do not im-

pact personal privacy. Individuals either elect whether to avail themselves of the provisions of the committee amendment to the bill or are subject to the committee amendment to the bill for en-gaging in certain tax avoidance transactions. The bill does not im-pose increased paperwork burdens on individuals. Individuals who elect to take advantage of provisions in the committee amendment to the bill may in some cases need to keep records in order to dem-onstrate that they qualify for the treatment provided. Individuals who elect to engage in tax avoidance transactions, and certain advi-sors who provide material aid, assistance, or advice with respect to such transactions, may in some cases need to file certain disclosure statements with the IRS.

B. UNFUNDED MANDATES STATEMENT

The information is provided in accordance with section 423 of the Unfunded Mandates Reform Act of 1995 (P.L. 104–4).

The Committee has determined that the following provisions of the bill contain Federal mandates on the private sector: (1) provi-sions relating to reportable transactions and tax shelters; (2) modi-fications to the substantial understatement penalty; (3) actions to enjoin conduct with respect to tax shelters; (4) understatement of taxpayer’s liability by an income tax return preparer; (5) the impo-



sition of a civil penalty (of up to $5,000) on a failure to report inter-est in foreign financial accounts; (6) frivolous tax submissions; and (7) provisions relating to the tax treatment of inversion trans-actions and reinsurance agreements.

The costs required to comply with each Federal private sector mandate generally are no greater than the estimated budget effect of the provision. Benefits from the provisions include improved ad-ministration of the Federal income tax laws and a more accurate measurement of income for Federal income tax purposes.

C. TAX COMPLEXITY ANALYSIS

Section 4022(b) of the Internal Revenue Service Reform and Re-structuring Act of 1998 (the ‘‘IRS Reform Act’’) requires the Joint Committee on Taxation (in consultation with the Internal Revenue Service and the Department of the Treasury) to provide a tax com-plexity analysis. The complexity analysis is required for all legisla-tion reported by the Senate Committee on Finance, the House Committee on Ways and Means, or any committee of conference if the legislation includes a provision that directly or indirectly amends the Internal Revenue Code (the ‘‘Code’’) and has wide-spread applicability to individuals or small businesses. For each such provision identified by the staff of the Joint Committee on Taxation, a summary description of the provision is provided, along with an estimate of the number and type of affected taxpayers, and a discussion regarding the relevant complexity and administrative issues. Following the analysis of the staff of the Joint Committee on Taxation are the comments of the IRS regarding each provision included in the complexity analysis, including a discussion of the likely effect on IRS forms and any expected impact on the IRS.

Direct charitable deduction for nonitemizers (sec. 101 of the bill)

Summary description of provision In the case of an individual taxpayer who does not itemize deduc-

tions, the bill would allow a direct charitable deduction from ad-justed gross income for charitable contributions paid in cash. This deduction would be allowed in addition to the standard deduction. The deduction would be available only for that portion of contribu-tions that in the aggregate exceed $250 ($500 in the case of a joint return). The maximum deduction would be $250 ($500 in the case of a joint return). The direct charitable deduction generally would be subject to the tax rules normally governing charitable contribu-tion deductions, such as the substantiation requirements. The de-duction would be allowed in computing alternative minimum tax-able income. The direct charitable deduction would be effective for taxable years beginning after December 31, 2001, and before Janu-ary 1, 2004.

Number of affected taxpayers It is estimated that the provision could affect up to 85 million in-

dividual income tax returns each year the deduction is in effect.

Discussion Individuals who do not itemize their deductions will need to keep

additional records (e.g., canceled checks, a receipt from the donee


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organization, or other reliable written records) in order to substan-tiate that a contribution was made to a qualified charitable organi-zation. The information necessary to implement the provision should be readily available to taxpayers (in the form of new tax re-turn forms and instructions). The direct charitable deduction is ex-pected to require an additional line on the individual income tax return forms. The provision might result in an increase in disputes with the IRS for taxpayers who are unable to substantiate a claimed deduction. Additional regulatory guidance will not be nec-essary to implement this provision. Any increase in tax preparation costs is expected be negligible.



(113)

DEPARTMENT OF THE TREASURY, INTERNAL REVENUE SERVICE,

Washington, DC, June 24, 2002. Ms. LINDY L. PAULL, Chief of Staff, Joint Committee on Taxation, Washington, DC.

DEAR MS. PAULL: Enclosed are the combined comments of the In-ternal Revenue Service and the Treasury Department on the provi-sion for a charitable deduction for non-itemizers from the Senate Finance Committee’s markup of H.R. 7 the ‘‘Care Act of 2002,’’ that you identified for complexity analysis in your letter of June 19, 2002. Our comments are based on the description of that provision in your letter and in JCX–57–02, Joint Committee on Taxation, De-scription of the Care Act of 2002, June 11, 2002.

Due to the short turnaround time, our comments are provisional and subject to change upon a more complete and in-depth analysis of the provision.

Sincerely, CHARLES O. ROSSOTTI,

Commissioner. Enclosure.

COMPLEXITY ANALYSIS OF PROVISION FROM H.R. 7, THE CARE ACT OF 2002

CHARITABLE DEDUCTION FOR NON-ITEMIZERS

Provision: Taxpayers who do not itemize would be allowed to de-duct their cash contributions to qualified charitable organizations in addition to claiming the standard deduction. This deduction would be calculated as the lesser of (a) the excess, if any, of the charitable contributions over $250 ($500 in the case of a joint re-turn) or (b) $250 ($500 in the case of a joint return). The tax rules that apply to the charitable contribution deduction allowed to itemizers would generally apply to this deduction. The non-itemizer deduction would not be a preference item for purposes of the alter-native minimum tax and would not affect the calculation of ad-justed gross income (AGI). The proposal would be effective for tax years beginning after December 31, 2001, and before January 1, 2004.

IRS and Treasury comments Two lines would have to be added to Forms 1040, 1040A,

1040EZ, 1040NR, and 1040NR–EZ for 2002 and 2003; one for the allowable deduction and one to reflect the total of the standard de-duction and the charitable contribution deduction. One line would be added to the TeleFile Tax Record for 2002 and 2003 (taxpayers


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would enter their total contributions on the new line and TeleFile would calculate the allowable deduction). No new forms would be required.

The new deduction would also have to be reflected on Form 1040–ES for 2003 and in the instructions for Forms 1040X and 1045 for 2002 and 2003. Subsequent to enactment, the IRS may have to advise taxpayers who make estimated tax payments for 2002 how they can adjust their estimated tax payments for 2002 to reflect the new deduction.

Information necessary for taxpayers to determine their eligibility for the deduction, including the AGI limitation applicable to cash contributions, and the substantiation requirements would have to be reflected in the 2002 and 2003 instructions for Forms 1040, 1040A, 1040EZ, 1040NR, and 1040NR–EZ and for TeleFile.

A worksheet (consisting of four lines) for taxpayers to calculate their allowable deduction would have to be reflected in the 2002 and 2003 instructions for Forms 1040, 1040A, 1040EZ, 1040NR, and 1040NR–EZ.

Changes to the Telefile script for 2002 and 2003 would be re-quired to allow the deduction to taxpayers who use TeleFile.

All of the above changes would have to be reversed for tax years beginning after December 31, 2003, to reflect the termination of the charitable deduction for non-itemizers (e.g., the lines would be re-moved from the Form 1040 series of returns, the worksheet would be removed from the instructions for these returns, and program-ming and script changes would be necessary to eliminate the de-duction).

Ensuring compliance with the new charitable deduction would be difficult. The only means of verifying amounts deducted would be through examination, which is not practical because of the rel-atively small amounts involved.

The direct charitable deduction line on the 2002 and 2003 Form 1040 series of returns would need to be transcribed and incor-porated into our computation of taxable income. The programming changes needed to effectuate this for 2003 processing (of 2002 re-turns) will put a strain on IRS’ ability to complete and test other programming needed for the 2003 filing season. Since IRS is well into its program development for January 2003, we recommend that the effective date be delayed so that the provision would be effective for tax years beginning in 2003 and 2004. A delayed effec-tive date would be especially important if the provision were not enacted before September 2002.

VI. CHANGES IN EXISTING LAW MADE BY THE BILL AS REPORTED

In the opinion of the Committee, it is necessary in order to expe-dite the business of the Senate, to dispense with the requirements of paragraph 12 of rule XXVI of the Standing Rules of the Senate (relating to the showing of changes in existing law made by the bill as reported by the Committee).

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